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Florida Public Utilities Company (“FPU” or “Company”)

 Part I.  

Financial Information

Item 1.

Financial Statements

Condensed Consolidated Statements of Operations

Condensed Consolidated Balance Sheets

Condensed Consolidated Statements of Cash Flows

Notes to Condensed Consolidated Financial Statements

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

Item 4.

Controls and Procedures

Part II.  Other Information

Item 1.

Legal Proceedings

Item 2.

Changes in Securities and Use of Proceeds

Item 3.

Defaults Upon Senior Securities

Item 4.

Submission of Matters to a Vote of Security Holders

Item 5.

Other Information

Item 6.

Exhibits and Reports on Form 8-K

Signatures

PART I

Financial Information

Item 1.  Financial Statements

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FLORIDA PUBLIC UTILITIES COMPANY

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2003

1.

In the opinion of Management, the accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("generally accepted accounting principles") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. All adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Due to the seasonal nature of the Company's business, the operating results for the period are not necessarily indicative of the results that may be expected for the full year. For further information, refer to the audited consolidated financial statements and foo tnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2002.

2.

Average shares outstanding and dividends per common share have been restated to reflect the four-for-three stock split declared on June 14, 2002 and distributed on July 1, 2002.

3.

Substantially all of the Company’s utility plant and the shares of Flo-Gas Corporation collateralize the Company's First Mortgage Bonds. Investments held for environmental costs, accounts receivable, and inventory are collateral for the line of credit.

4.

The First Mortgage Bond Indentures provide for restrictions on the payment of cash dividends.  As of September 30, 2003, under the most restrictive provision, approximately $4,600,000 of retained earnings were unrestricted. The line of credit agreement contains covenants that, if violated, could restrict the issuance of dividends. The Company is not in violation of these covenants; however, if a material violation occurs in the future and is not rectified, it could prohibit the issuance of dividends.

5.

Summary of Revenues and Operating income before income taxes (dollars in thousands):

6.

Goodwill and Other Intangible Assets

Effective January 1, 2002, the Company adopted Financial Accounting Standards No. (FAS) 142, "Goodwill and Other Intangible Assets." Under this statement, the amortization of goodwill is no longer permitted and intangible assets with an indefinite life will not be amortized. The standard requires goodwill to be periodically tested for impairment and written down to fair value if considered impaired.  The reporting units have been determined to be propane gas and natural gas for the purposes of impairment testing.

Intangible assets associated with our recent acquisitions have been identified and are shown as a separate line item on the balance sheet.  The intangibles subject to amortization over a five-year period are non-compete agreements totaling $35,000, and the amount of amortization was $12,413.  The remaining intangibles identified are customer distribution rights for $1,900,000 and customer relationships for $900,000, both of which have indefinite lives and are not subject to amortization.

All goodwill relates to the recent gas acquisitions and accordingly, there is no amortization of goodwill reported in the accompanied financial statements. The test for goodwill impairment was performed at December 31, 2002 for the reporting units. The test results show there is currently no impairment in either reporting unit.   

7.

Financial Accounting Standard No. 143

In August 2001, the Financial Accounting Standard Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for Asset Retirement Obligations.” The statement requires that the fair value of an asset retirement obligation be recognized at the time those obligations are incurred. Upon initial recognition of a legal liability, costs are capitalized as part of the related long-lived asset and allocated to expense over the useful life of the asset.  SFAS No. 143 also requires that components of previously recorded depreciation related to the cost of removal of assets upon retirement, whether legal asset retirement obligations or not, be removed from a company’s accumulated depreciation reserve. SFAS No. 143 is effective for fiscal years begi nning after June 15, 2002.  The Company adopted the provisions of the Statement as of January 1, 2003, as prescribed by the Florida Public Service Commission (“FPSC”).  Under FPSC guidelines, the estimated cost of removal expenses for normal retirements related to regulated fixed assets are reserved through the depreciation expense and accumulated reserves. The estimated value of the reserve that has been accumulated for future cost of removal as of September 30, 2003 is approximately $6,000,000 and is included in accumulated depreciation in the accompanying condensed consolidated financial statements.  The Company has determined that it does not have any material legal obligations for asset retirements and that the adoption of SFAS No. 143 did not have a material impact on the Company’s financial statements. The Company will continue monitoring the handling of utility long-lived assets for interpretations of assets that may be considered to have legal retirement obligations.

Financial Accounting Standard No. 149

In April 2003, the Financial Accounting Standard Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.”  This statement clarifies the circumstances under which a contract with an initial net investment becomes a derivative, and clarifies when a derivative contains a financing component.  As the Company has designated all material contracts meeting the definition of possible derivative instruments as “normal purchases and sales” under SFAS No. 133, “Accounting for Derivatives”, this statement will not impact the Company.

8.

Mergers and Acquisitions

On November 1, 2002, the Company acquired Nature Coast Utilities, a propane gas service distribution company, for approximately $740,000 in a cash-for-stock transaction.  The merger added about 1,200 customers to the propane operation in the Company’s new Nature Coast Division located in West Central Florida.  

9.

Gain on Sale of Property

The Company sold property held in Delray Beach, in its South Florida division, for a gain of approximately $529,000 in the first quarter of 2002.  This property was primarily regulated property, and accordingly, the majority of the gain was deferred awaiting Florida Public Service Commission (FPSC) approval on the disposition of that gain. The Company has been granted approval by the FPSC to allow amortization of the gain with an offset to depreciation expense over five years beginning in April, 2002. The non-regulated portion of the gain has been recognized in the first quarter of 2002 and amounts to $53,000, net of income taxes.

The Company sold property held in Deland, in our Central Florida division, for a gain of approximately $186,000 during the third quarter of 2002.  This property was primarily regulated property and accordingly the majority of the gain was deferred awaiting FPSC approval on the disposition of that gain.  The Company has been granted approval by the FPSC to allow amortization of the gain with an offset to depreciation expense over five years beginning in August 2002.  The non-regulated portion of the gain has been recognized in the third quarter of 2002 and amounts to $17,000, net of income taxes.

10.

Discontinued Operations

On December 3, 2002, the Company entered into an agreement to sell certain assets comprising its water utility system to the City of Fernandina Beach (“City”). The closing of this transaction took place on March 27, 2003.  The City paid the Company $19,242,000 in cash at closing, as well as future consideration of approximately $7,400,000 to be received annually (as defined) until February 15, 2010, when the Company will receive the final payment from the City. The net proceeds from the sale resulted in the payoff of the notes payable balance.  The Company recognized and recorded the present value of the long-term receivable in the amount of $5,716,000, using a discount rate of 4.34%. The long-term receivable has been subsequently increased to recognize interest income in the amount of $125,000.  The fair value of the consideration is approximately $25,000,000. The gain on the disp osal of Discontinued Operations including the income from discontinued operations for the first quarter of 2003, was $15,842,000 or $9,882,000 after tax, and has subsequently been adjusted to $15,736,000 or $9,816,000 after tax due to additional expenses relating to the sale.  

The accompanying condensed consolidated financial statements have been restated for all periods presented for the discontinued operations of the water division. The Company did not cease recording depreciation expense due to the regulatory requirements and continued to record depreciation through the sales date of March 27, 2003. The total net plant amounted to approximately $9,728,000, and the net assets less liabilities amounted to approximately $8,909,000 at the date of sale. The assets and liabilities of the water division have been included in current assets and current liabilities as of December 31, 2002, as assets and liabilities held for sale.  

Estimated Annual Future Value of Consideration expected from the City for years following 12/31/03 is as follows (dollars in thousands):

Results of discontinued operations were as follows:

The major balance sheet classes included in assets and liabilities of discontinued operations in the Condensed Consolidated Balance Sheets, as of December 31, 2002, is as follows:

11.

Environmental Contingencies

The Company is subject to federal and state legislation with respect to soil, groundwater and employee health and safety matters and to environmental regulations issued by the Florida Department of Environmental Protection (FDEP), the United States Environmental Protection Agency (EPA) and other federal and state agencies.  Except as discussed below, the Company does not expect to incur material future expenditures for compliance with existing environmental laws and regulations.

West Palm Beach Site.

FPUC is currently evaluating remedial options to respond to environmental impacts to soil and groundwater at and in the immediate vicinity of a parcel of property owned by it in West Palm Beach, Florida upon which FPUC previously operated a gasification plant.  FPUC entered into a consent order with the Florida Department of Environmental Protection ("FDEP") effective April 8, 1991, that requires FPUC to delineate the extent of soil and groundwater impacts associated with the prior operation of the gasification plant and to remediate such soil and groundwater impacts, if necessary. Numerous reports have been submitted by FPUC to FDEP, describing the results of soil and groundwater sampling conducted at the site. A Supplemental Contamination Assessment Report Addendum (“SCARA”) was submitted to FDEP in December 2001, summarizing the results of past investiga tions and providing the results of additional field work conducted in 2001, in response to comments received previously from FDEP.  On September 29, 2003, FPUC submitted to FDEP a Comprehensive Soil and Groundwater Assessment Report, that described the results of substantial additional field work undertaken in 2003 to respond to FDEP's comments to the SCARA.

FPUC recently authorized its consultant to begin work on a feasibility study to evaluate an appropriate remedial response to the soil and groundwater impacts associated with the former operation of the West Palm Beach gasification plant.  The feasibility study is expected to be completed in early 2004.

Prior to completion of the feasibility study, FPUC is unable to determine the complete extent or cost of remedial action which may be required.  Based on findings from the recently completed 2003 field work, remediation costs (including attorneys' fees) for this site may range from up to $11.2 million to $12.6 million.  A portion of the on-site impacts attributable to past petroleum releases have been determined to be eligible for reimbursement from a state fund, and the FDEP has determined that a portion of the work conducted off-site may be eligible for reimbursement under state law.

Sanford Site.

FPUC owns a parcel of property located in Sanford, Florida, upon which a gasification plant was operated prior to FPUC's acquisition of the property.  Following discovery of soil and groundwater impacts on the property, FPUC has participated with four former owners and operators of the gasification plant in the funding of numerous investigations of the extent of the impacts and the identification of an appropriate remedy.  On or about March 25, 1998, FPUC executed an Administrative Order on Consent (“AOC”) with the four former owners and operators (collectively, the “Group”) and the United States Environmental Protection Agency ("EPA") that obligated the Group to implement a Remedial Investigation/Feasibility Study (“RI/FS”) task and to pay EPA’s past and future oversight costs for the RI/FS.  The Group also entered into a Participation Agreement and an Escrow Agreement on or about April 13, 1998 ("RI/FS Participation Agreement").  These agreements governed the manner and means by which all parties were to satisfy their respective obligations under the AOC for the RI/FS task.  FPUC agreed to pay approximately 13.7% of the cost for the RI/FS.  Field work for the RI/FS was initiated in 1998.  A final RI report was submitted to EPA in July 1999. The Group also submitted a Baseline Risk Assessment to EPA in January 2000, including an Ecological Risk Assessment (“ERA”).  FPUC's share of the cost of these tasks was previously paid in full.  The RI/FS Participation Agreement was amended on September 18, 2003, to authorize an additional $400,000 to be incurred by the Group to complete the ecological risk assessment and cover EPA oversight costs for the RI/FS.  FPUC's share of the additional funding is 13.7%, or $54,822.40, which is expected to be paid by FPUC in November 2003. &n bsp;    

On July 5, 2000, EPA issued a Record of Decision ("ROD") approving the final remedial action for contaminated soils at the site ("OU1 Remedy"). The initial estimated cost for the OU1 Remedy described in the ROD ranges from $5,593,000 to $5,760,000.  On June 12, 2001, EPA issued a ROD approving the final remedial action for contaminated groundwater at the site  ("OU2 Remedy").  The present worth cost estimate for the OU2 Remedy is $320,252.  

Pre-remedial design field work was performed in 2002-03 to assist in the design of the final remedy for OU1 and OU2.  The cost of the additional field and design work was approximately $1,100,000.  FPUC previously paid its share of these costs.   Upon EPA's approval of the final design, the Group will be obligated to implement the remedy for OU1 and OU2.  Based on the pre-remedial design field work, it is now anticipated that the final cost of the remedy for OU1 and OU2 will significantly exceed the $6,000,000 combined estimate provided in the RODs for OU1 and OU2. Pursuant to the terms and conditions of the Second Participation Agreement entered into by members of the Group on August 1, 2000, FPUC's share of costs for implementation of the OU1 Remedy and OU2 Remedy, including the pre-remedial design fieldwork, is 10.5% of the cost for the final remedy, pro viding the total cost of the final remedy, including the pre-remedial design fieldwork, does not exceed $6,000,000.  FPUC has notified Group members that FPUC will oppose any effort by the Group to increase FPUC's share of total remedial costs above 10.5% of the current $6,000,000 cap, since the increased remedial cost is due to the discovery of additional impacted soils on property not owned by FPUC.  

Summary

The Company records environmental costs when it is probable it is liable for the costs and it can reasonably estimate the liability. The Company may defer costs as a regulatory asset based on the expectation that it will recover these costs from customers in future rates. Otherwise, the Company expenses the costs. The estimates are based on experience, the assessment of the current situation and the technology currently available for use in the remediation. The Company adjusts the recorded costs as it revises estimates and as remediation proceeds. If the Company is one of several designated responsible parties, it estimates and records only its share of the cost.

On September 30, 2003 the estimated remaining costs for consulting and remediation, legal expenses, and other related expenses for the sites ranges from approximately $12 million to $13.2 million. The Company currently has $12 million reserved as an environmental liability; consisting of $5 million for costs already recovered and $7 million accrued for pending future rate relief, that must be authorized by the FPSC. Based on existing information, management believes that all future contamination assessment and remedial costs, legal fees and other related costs will not be in excess of the rate relief granted by the FPSC currently or in the future. The Company has petitioned the FPSC and was granted the right to apply any over earnings in 2003 in the natural gas segment to the environmental liability.

12.

Use of Estimates

Amounts recorded for over earnings are based on estimates of year-end financial results.  These estimates may significantly vary depending on weather, actual results versus budgeted results, and variations in the cost of capital components.

13.

Common Shareholders’ Equity

Additional items impacting Common shareholders’ equity other than income and dividends are the Company’s dividend reinvestment program and the issuance of treasury stock in the amount of approximately $412,000.

Item 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary statements and risk factors that may affect future results.

This Quarterly Report on Form 10-Q contains forward-looking statements, which involve the use of estimates and assumptions and are subject to the inherent uncertainties in predicting future results and conditions. Certain factors such as weather conditions, changes in laws or regulations, changes in the market environment, restrictions on ability to raise capital on favorable terms, direct and indirect effects of terrorist threats and activities, and the ability to identify attractive acquisition opportunities at favorable prices and to successfully and timely complete and integrate them could cause actual results to differ materially from those projected in these forward-looking statements. Additional issues may also arise or become material as the energy industry evolves which could impair the business of Florida Public Utilities Company.

Financial Condition.

In April 2003, the Company closed an expiring $20 million line of credit (“LOC”). The LOC had a $16.1 million outstanding balance on March 27, 2003, that was repaid using proceeds from the sale of the water division. On March 27, the Company received $19.2 million in cash, along with future consideration valued at $5.7 million, for the water division (for additional information see "Discontinued Operations" in the Notes to Condensed Consolidated Financial Statements). On April 1, 2003 the Company opened a $12 million, three-year line of credit, the current outstanding balance of which is $770,000. The Company reserves $1 million of the LOC to cover expenses for any major storm repairs in its Northwest Florida division. An additional $250,000 of the LOC is reserved for a ‘letter of credit’ insuring propane facilities. Construction expenditures are budgeted at approximately $16 million in 2004 to perform system upgrades. Additional financing of approximately $12 million will be needed in the short term to finance the projected construction. Without additional financing the system upgrades would be deferred. Based on the Company’s current financing structure and business environment it is likely the additional financing will be provided by the issuance of equity. Notes payable, long-term debt and preferred stock on September 30, 2003 comprise 56% of total capitalization, with equity of 44%.  The stronger equity ratio was a result of selling the water assets for a $9.8 million gain net of income taxes.

Net cash flow provided by continuing operating activities decreased from 2002.  Over $2,900,000 in taxes relating to the gain on the sale of the water division was paid in the second quarter.  This was offset by a decrease in accounts receivable of approximately $800,000.  Net cash flow of $98,000 was used by discontinued operations during 2003 as a result of the legal expenses associated with the sale of the water assets. Construction expenditures decreased $5.8 million in 2003, compared to 2002, primarily due to approximately $2 million of additional construction in 2002 relating to the Lake Worth generation project, and a $1.5 million contribution in 2003 from the transportation agreement with the City of Lake Worth.  In 2002 the Company had funds classified as restricted proceeds from the private activity bond acquired in late 2001.  As construction progressed, the balance of these restricted pro ceeds decreased, and was fully unrestricted in 2003.  Cash from ‘investing activities, other’, decreased due to the reduction in the balance of customer advances for construction.   

Overview.

The Company is organized into two regulated business segments, natural gas and electric, and one non-regulated business segment, propane gas. There are no material inter-segment sales or transfers.

Definitions.

Gross Profit.  Gross Profit, defined as gross operating revenues less fuel costs, conservation and unbundling costs, and taxes based on revenues that are passed through to customers, provides a meaningful basis for evaluating utility operations. Fuel, conservation, and unbundling costs along with taxes passed through to customers have no effect on results of operations, and fluctuations in such costs distort the relationship of gross operating revenues and gross profit (net revenues retained by the Company for operating purposes).

Operating Expenses.  Operating expenses exclude fuel costs, conservation and unbundling costs, and taxes based on revenues that are passed through to customers. These operating expenses have no effect on results of operations as they are passed on directly to customers, and fluctuations in such costs distort the relationship of operating expenses between periods. These costs are grouped on a separate line of the income statement as “Cost of fuel and taxes based on revenues”.