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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark One)
/X/ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended JUNE 30, 2004
or
/ / Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
Commission File No. 1-3548
ALLETE, INC.
A Minnesota Corporation
IRS Employer Identification No. 41-0418150
30 West Superior Street
Duluth, Minnesota 55802-2093
Telephone - (218) 279-5000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months and (2) has been subject to such filing requirements for
the past 90 days.
Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
----- -----
Common Stock, no par value,
88,647,015 shares outstanding
as of July 31, 2004
INDEX
Page
Definitions 2
Safe Harbor Statement Under the Private Securities
Litigation Reform Act of 1995 3
Part I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheet -
June 30, 2004 and December 31, 2003 4
Consolidated Statement of Income -
Quarter and Six Months Ended June 30, 2004 and 2003 5
Consolidated Statement of Cash Flows -
Six Months Ended June 30, 2004 and 2003 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 19
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 28
Item 4. Controls and Procedures 30
Part II. Other Information
Item 1. Legal Proceedings 30
Item 2. Changes in Securities, Use of Proceeds and
Issuer Purchases of Equity Securities 30
Item 4. Submission of Matters to a Vote of Security Holders 31
Item 5. Other Information 31
Item 6. Exhibits and Reports on Form 8-K 33
Signatures 35
1 ALLETE Second Quarter 2004 Form 10-Q
DEFINITIONS
The following abbreviations or acronyms are used in the text. References in this
report to "we," "us" and "our" are to ALLETE, Inc. and its subsidiaries,
collectively.
ABBREVIATION OR ACRONYM TERM
- --------------------------------------------------------------------------------
2003 Form 10-K ALLETE's Annual Report on Form 10-K for
the Year Ended December 31, 2003
Aqua America Aqua America, Inc.
ADESA ADESA, Inc.
ADESA Impact Collectively, Automotive Recovery Services,
Inc. and Impact Auto Auctions Ltd.
ADESA Importation ADESA Importation Services, Inc.
AFC Automotive Finance Corporation
ALLETE ALLETE, Inc.
ALLETE Properties ALLETE Properties, Inc.
APB Accounting Principles Board
Company ALLETE, Inc. and its subsidiaries
EBITDA Earnings Before Interest, Taxes,
Depreciation and Amortization Expense
EPA Environmental Protection Agency
ESOP Employee Stock Ownership Plan
FASB Financial Accounting Standards Board
FERC Federal Energy Regulatory Commission
Florida Water Florida Water Services Corporation
FPSC Florida Public Service Commission
GAAP Generally Accepted Accounting Principles in
the United States
GeoInsight GeoInsight, Inc.
IPO Initial Public Offering
MTBE Methyl Tertiary-Butyl Ether
Minnesota Power An operating division of ALLETE, Inc.
Minnkota Power Minnkota Power Cooperative, Inc.
MPUC Minnesota Public Utilities Commission
MW Megawatt(s)
Note ___ Note ___ to the consolidated financial
statements in this Form 10-Q
NRG Energy NRG Energy, Inc.
NYSE New York Stock Exchange
PSCW Public Service Commission of Wisconsin
SEC Securities and Exchange Commission
SFAS Statement of Financial Accounting Standards
No.
Split Rock Energy Split Rock Energy LLC
Square Butte Square Butte Electric Cooperative
SWL&P Superior Water, Light and Power Company
Taconite Harbor Taconite Harbor Energy Center
WDNR Wisconsin Department of Natural Resources
ALLETE Second Quarter 2004 Form 10-Q 2
SAFE HARBOR STATEMENT
UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
In connection with the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995, we are hereby filing cautionary statements
identifying important factors that could cause our actual results to differ
materially from those projected in forward-looking statements (as such term is
defined in the Private Securities Litigation Reform Act of 1995) made by or on
behalf of ALLETE in this Quarterly Report on Form 10-Q, in presentations, in
response to questions or otherwise. Any statements that express, or involve
discussions as to, expectations, beliefs, plans, objectives, assumptions or
future events or performance (often, but not always, through the use of words or
phrases such as "anticipates," "believes," "estimates," "expects," "intends,"
"plans," "projects," "will likely result," "will continue" or similar
expressions) are not statements of historical facts and may be forward-looking.
Forward-looking statements involve estimates, assumptions, risks and
uncertainties and are qualified in their entirety by reference to, and are
accompanied by, the following important factors, which are difficult to predict,
contain uncertainties, are beyond our control and may cause actual results or
outcomes to differ materially from those contained in forward-looking
statements:
- our ability to successfully implement our strategic objectives, including
the completion and impact of the planned spin-off of our Automotive
Services business;
- war and acts of terrorism;
- prevailing governmental policies and regulatory actions, including those of
the United States Congress, Canadian federal government, state and
provincial legislatures, the FERC, the MPUC, the FPSC, the PSCW, and
various county regulators and city administrators, about allowed rates of
return, financings, industry and rate structure, acquisition and disposal
of assets and facilities, operation and construction of plant facilities,
recovery of purchased power and capital investments, and present or
prospective wholesale and retail competition (including but not limited to
transmission costs) as well as vehicle-related laws, including vehicle
brokerage and auction laws;
- unanticipated effects of restructuring initiatives in the electric and
automotive industries;
- economic and geographic factors, including political and economic risks;
- changes in and compliance with environmental and safety laws and policies;
- weather conditions;
- natural disasters;
- market factors affecting supply and demand for used vehicles;
- wholesale power market conditions;
- population growth rates and demographic patterns;
- the effects of competition, including competition for retail and wholesale
customers, as well as sellers and buyers of vehicles;
- pricing and transportation of commodities;
- changes in tax rates or policies or in rates of inflation;
- unanticipated project delays or changes in project costs;
- unanticipated changes in operating expenses and capital expenditures;
- capital market conditions;
- competition for economic expansion or development opportunities;
- our ability to manage expansion and integrate acquisitions; and
- the outcome of legal and administrative proceedings (whether civil or
criminal) and settlements that affect the business and profitability of
ALLETE.
Additional disclosures regarding factors that could cause our results and
performance to differ from results or performance anticipated by this report are
discussed in Item 7. under the heading "Factors that May Affect Future Results"
beginning on page 46 of our 2003 Form 10-K. Any forward-looking statement speaks
only as of the date on which such statement is made, and we undertake no
obligation to update any forward-looking statement to reflect events or
circumstances after the date on which that statement is made or to reflect the
occurrence of unanticipated events. New factors emerge from time to time and it
is not possible for management to predict all of these factors, nor can it
assess the impact of each of these factors on the businesses of ALLETE or the
extent to which any factor, or combination of factors, may cause actual results
to differ materially from those contained in any forward-looking statement.
Readers are urged to carefully review and consider the various disclosures made
by us in our 2003 Form 10-K and in our other reports filed with the SEC that
attempt to advise interested parties of the factors that may affect our
business.
3 ALLETE Second Quarter 2004 Form 10-Q
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ALLETE
CONSOLIDATED BALANCE SHEET
Millions - Unaudited
JUNE 30, DECEMBER 31,
2004 2003
- --------------------------------------------------------------------------------------------------------------------
ASSETS
Current Assets
Cash and Cash Equivalents $ 602.9 $ 219.6
Restricted Cash 155.8 3.4
Accounts Receivable (Less Allowance of $14.1 and $26.4) 551.3 403.8
Inventories 40.7 37.9
Prepayments and Other 15.6 15.8
Discontinued Operations 9.6 14.9
- --------------------------------------------------------------------------------------------------------------------
Total Current Assets 1,375.9 695.4
Property, Plant and Equipment - Net 1,484.7 1,499.0
Investments 184.6 204.6
Goodwill 509.5 511.0
Other Intangible Assets 30.7 33.3
Other Assets 88.0 70.1
Discontinued Operations 8.2 87.9
- --------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $3,681.6 $3,101.3
- --------------------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Current Liabilities
Accounts Payable $ 396.0 $ 243.9
Accrued Taxes and Interest 43.5 35.2
Notes Payable - 53.0
Long-Term Debt Due Within One Year 320.1 37.5
Other 98.8 107.1
Discontinued Operations 15.0 49.5
- --------------------------------------------------------------------------------------------------------------------
Total Current Liabilities 873.4 526.2
Long-Term Debt 790.9 747.7
Accumulated Deferred Income Taxes 182.2 160.7
Minority Interest 74.3 8.4
Other Liabilities 157.5 153.1
Discontinued Operations 2.7 45.0
Commitments and Contingencies
- --------------------------------------------------------------------------------------------------------------------
Total Liabilities 2,081.0 1,641.1
- --------------------------------------------------------------------------------------------------------------------
SHAREHOLDERS' EQUITY
Common Stock Without Par Value, 130.0 Shares Authorized
88.6 and 87.3 Shares Outstanding 963.7 859.2
Unearned ESOP Shares (43.8) (45.4)
Accumulated Other Comprehensive Gain 8.4 14.5
Retained Earnings 672.3 631.9
- --------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 1,600.6 1,460.2
- --------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $3,681.6 $3,101.3
- --------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these statements.
ALLETE Second Quarter 2004 Form 10-Q 4
ALLETE
CONSOLIDATED STATEMENT OF INCOME
Millions Except Per Share Amounts - Unaudited
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------
OPERATING REVENUE
Energy Services
Regulated Utility $136.9 $125.8 $278.3 $263.8
Nonregulated 47.0 32.7 87.9 73.8
Automotive Services 232.1 240.7 479.8 473.6
Investments (0.7) 10.7 27.8 21.6
- --------------------------------------------------------------------------------------------------------------------
Total Operating Revenue 415.3 409.9 873.8 832.8
- --------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Fuel and Purchased Power
Regulated Utility 65.9 56.8 123.0 112.8
Nonregulated 11.3 8.1 23.1 19.5
Operations
Regulated Utility 53.2 52.5 110.6 110.3
Nonregulated 33.7 24.5 62.2 52.8
Automotive and Investments 180.7 189.9 384.1 380.0
Interest 13.8 16.0 26.9 32.9
- --------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 358.6 347.8 729.9 708.3
- --------------------------------------------------------------------------------------------------------------------
OPERATING INCOME FROM CONTINUING OPERATIONS 56.7 62.1 143.9 124.5
INCOME TAX EXPENSE 23.8 25.0 57.9 49.4
- --------------------------------------------------------------------------------------------------------------------
INCOME FROM CONTINUING OPERATIONS 32.9 37.1 86.0 75.1
INCOME FROM
DISCONTINUED OPERATIONS - NET OF TAX 1.8 7.3 1.2 13.6
- --------------------------------------------------------------------------------------------------------------------
NET INCOME $ 34.7 $ 44.4 $ 87.2 $ 88.7
- --------------------------------------------------------------------------------------------------------------------
AVERAGE SHARES OF COMMON STOCK
Basic 85.1 82.6 84.7 82.4
Diluted 85.6 82.9 85.2 82.6
- --------------------------------------------------------------------------------------------------------------------
BASIC EARNINGS PER SHARE OF COMMON STOCK
Continuing Operations $0.39 $0.45 $1.02 $0.91
Discontinued Operations 0.02 0.09 0.01 0.17
- --------------------------------------------------------------------------------------------------------------------
$0.41 $0.54 $1.03 $1.08
- --------------------------------------------------------------------------------------------------------------------
DILUTED EARNINGS PER SHARE OF COMMON STOCK
Continuing Operations $0.38 $0.45 $1.01 $0.91
Discontinued Operations 0.02 0.08 0.01 0.16
- --------------------------------------------------------------------------------------------------------------------
$0.40 $0.53 $1.02 $1.07
- --------------------------------------------------------------------------------------------------------------------
DIVIDENDS PER SHARE OF COMMON STOCK $0.2825 $0.2825 $0.565 $0.565
- --------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of these statements.
5 ALLETE Second Quarter 2004 Form 10-Q
ALLETE
CONSOLIDATED STATEMENT OF CASH FLOWS
Millions - Unaudited
SIX MONTHS ENDED
JUNE 30,
2004 2003
- --------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES
Net Income $ 87.2 $ 88.7
Depreciation and Amortization 43.0 42.9
Deferred Income Taxes 7.1 12.0
Gain on Sale of Plant (15.5) (17.0)
Changes in Operating Assets and Liabilities
Accounts Receivable (146.4) (84.8)
Inventories (1.8) 3.2
Prepayments and Other (0.2) (1.8)
Accounts Payable 118.7 54.6
Other Current Liabilities (13.2) (3.2)
Other Assets (4.1) 2.4
Other Liabilities 3.6 8.5
- --------------------------------------------------------------------------------------------------------------------
Cash from Operating Activities 78.4 105.5
- --------------------------------------------------------------------------------------------------------------------
INVESTING ACTIVITIES
Proceeds from Sale of Plant 75.4 -
Proceeds from Sale of Available-For-Sale Securities 1.6 6.4
Changes to Investments 16.3 (2.4)
Additions to Property, Plant and Equipment (43.4) (118.6)
Other (1.5) (15.0)
- --------------------------------------------------------------------------------------------------------------------
Cash from (for) Investing Activities 48.4 (129.6)
- --------------------------------------------------------------------------------------------------------------------
FINANCING ACTIVITIES
Issuance of Common Stock 34.9 17.8
Issuance of Subsidiary Common Stock 136.0 -
Issuance of Long-Term Debt 405.6 65.9
Net Increase in Book Overdrafts 31.2 70.8
Payments for Debt Issuance Costs (9.9) -
Changes in Notes Payable - Net (52.2) (72.9)
Reductions of Long-Term Debt (81.5) (3.2)
Dividends on Common Stock (46.8) (45.6)
Transfer to Restricted Cash (152.4) -
- --------------------------------------------------------------------------------------------------------------------
Cash from Financing Activities 264.9 32.8
- --------------------------------------------------------------------------------------------------------------------
EFFECT OF EXCHANGE RATE CHANGES ON CASH (6.4) 30.8
- --------------------------------------------------------------------------------------------------------------------
CHANGE IN CASH AND CASH EQUIVALENTS 385.3 39.5
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 226.1 203.0
- --------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $611.4 $242.5
- --------------------------------------------------------------------------------------------------------------------
SUPPLEMENTAL CASH FLOW INFORMATION
Cash Paid During the Period for
Interest - Net of Capitalized $26.4 $33.2
Income Taxes $59.6 $22.6
- --------------------------------------------------------------------------------------------------------------------
Included $8.5 million of cash from Discontinued Operations at June 30, 2004 ($9.7 million at June 30, 2003).
The accompanying notes are an integral part of these statements.
ALLETE Second Quarter 2004 Form 10-Q 6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The accompanying unaudited consolidated financial statements and notes should be
read in conjunction with our 2003 Form 10-K. In our opinion, all adjustments
necessary for a fair presentation of the results for the interim periods have
been included. The results of operations for an interim period may not give a
true indication of the results for the year.
NOTE 1. BUSINESS SEGMENTS
Millions
ENERGY SERVICES
--------------------- INVESTMENTS
REGULATED NON- AUTOMOTIVE AND CORPORATE
CONSOLIDATED UTILITY REGULATED SERVICES CHARGES
- -------------------------------------------------------------------------------------------------------------------
FOR THE QUARTER ENDED JUNE 30, 2004
Operating Revenue $415.3 $136.9 $ 47.0 $232.1 $(0.7)
Operation and Other Expense 323.5 109.2 42.4 165.2 6.7
Depreciation and Amortization Expense 21.3 9.9 2.6 8.8 -
Interest Expense 13.8 4.6 0.6 4.7 3.9
- -------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) from
Continuing Operations 56.7 13.2 1.4 53.4 (11.3)
Income Tax Expense (Benefit) 23.8 5.0 0.3 21.1 (2.6)
- -------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations 32.9 8.2 1.1 32.3 (8.7)
Income (Loss) from
Discontinued Operations - Net of Tax 1.8 - - (4.0) -
- -------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $ 34.7 $8.2 $ 1.1 $ 28.3 $(8.7)
- -------------------------------------------------------------------------------------------------------------------
FOR THE QUARTER ENDED JUNE 30, 2003
Operating Revenue $409.9 $125.8 $ 32.7 $240.7 $10.7
Operation and Other Expense 309.9 98.9 30.1 171.3 9.6
Depreciation and Amortization Expense 21.9 10.4 2.5 8.9 0.1
Interest Expense 16.0 5.0 0.7 3.7 6.6
- -------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) from
Continuing Operations 62.1 11.5 (0.6) 56.8 (5.6)
Income Tax Expense (Benefit) 25.0 4.6 (0.5) 22.7 (1.8)
- -------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations 37.1 6.9 (0.1) 34.1 (3.8)
Income (Loss) from
Discontinued Operations - Net of Tax 7.3 - - (0.1) -
- -------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $ 44.4 $ 6.9 $ (0.1) $ 34.0 $(3.8)
- -------------------------------------------------------------------------------------------------------------------
Included $5.8 million of income from the Water Services businesses in 2004 ($7.4 million in 2003).
Included $43.3 million of Canadian operating revenue in 2004 ($47.6 million in 2003).
7 ALLETE Second Quarter 2004 Form 10-Q
NOTE 1. BUSINESS SEGMENTS (CONTINUED)
Millions
ENERGY SERVICES
--------------------- INVESTMENTS
REGULATED NON- AUTOMOTIVE AND CORPORATE
CONSOLIDATED UTILITY REGULATED SERVICES CHARGES
- ---------------------------------------------------------------------------------------------------------------------
FOR THE SIX MONTHS ENDED JUNE 30, 2004
Operating Revenue $873.8 $278.3 $ 87.9 $479.8 $27.8
Operation and Other Expense 660.0 213.8 80.2 344.7 21.3
Depreciation and Amortization Expense 43.0 19.8 5.1 18.1 -
Interest Expense 26.9 9.3 0.9 8.7 8.0
- ---------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) from
Continuing Operations 143.9 35.4 1.7 108.3 (1.5)
Income Tax Expense 57.9 13.3 0.2 42.7 1.7
- ---------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations 86.0 22.1 1.5 65.6 (3.2)
Income (Loss) from
Discontinued Operations - Net of Tax 1.2 - - (4.0) -
- ---------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $ 87.2 $ 22.1 $ 1.5 $ 61.6 $(3.2)
- ---------------------------------------------------------------------------------------------------------------------
Total Assets $3,681.6 $1,212.4 $244.6 $2,076.8 $130.0
Property, Plant and Equipment - Net $1,484.7 $734.2 $190.7 $555.8 $4.0
Accumulated Depreciation $870.5 $709.2 $47.4 $113.9 -
Capital Expenditures $43.4 $27.9 $6.6 $5.7 $0.2
FOR THE SIX MONTHS ENDED JUNE 30, 2003
Operating Revenue $832.8 $263.8 $ 73.8 $ 473.6 $21.6
Operation and Other Expense 632.6 202.4 67.3 347.5 15.4
Depreciation and Amortization Expense 42.8 20.7 5.0 17.0 0.1
Interest Expense 32.9 10.2 1.1 8.1 13.5
- ---------------------------------------------------------------------------------------------------------------------
Operating Income (Loss) from
Continuing Operations 124.5 30.5 0.4 101.0 (7.4)
Income Tax Expense (Benefit) 49.4 12.2 (0.3) 40.2 (2.7)
- ---------------------------------------------------------------------------------------------------------------------
Income (Loss) from Continuing Operations 75.1 18.3 0.7 60.8 (4.7)
Income from Discontinued Operations - Net of Tax 13.6 - - 0.4 -
- ---------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $ 88.7 $ 18.3 $ 0.7 $ 61.2 $(4.7)
- ---------------------------------------------------------------------------------------------------------------------
Total Assets $3,409.2 $922.8 $214.5 $1,718.5 $163.3
Property, Plant and Equipment - Net $1,480.6 $730.5 $174.3 $571.8 $4.0
Accumulated Depreciation $819.7 $686.6 $40.1 $93.0 -
Capital Expenditures $67.5 $23.7 $14.4 $12.8 -
- ---------------------------------------------------------------------------------------------------------------------
Included $5.2 million of income from the Water Services businesses in 2004 ($13.2 million in 2003).
Discontinued Operations represented $17.8 million of total assets in 2004 ($390.1 million in 2003) and $3.0
million of capital expenditures in 2004 ($16.6 million in 2003).
Included $89.1 million of Canadian operating revenue in 2004 ($87.7 million in 2003).
Included $241.3 million of Canadian assets in 2004 ($214.6 million in 2003).
ALLETE Second Quarter 2004 Form 10-Q 8
NOTE 2. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
ACCOUNTS RECEIVABLE. AFC sells the majority of U.S. dollar denominated finance
receivables on a revolving basis to a wholly owned, bankruptcy remote, special
purpose subsidiary that is consolidated for accounting purposes. AFC and the
special purpose subsidiary amended its securitization agreement in June 2004
concurrent with the completion of ADESA's IPO. The agreement expires in January
2005 subject to annual renewal and allows for the revolving sale to a bank
conduit facility of up to a maximum of $500 million in undivided interests in
eligible finance receivables subject to committed liquidity. The special purpose
subsidiary had $425 million of committed liquidity at June 30, 2004. Receivables
sold are not reported on our consolidated financial statements. At June 30, 2004
AFC managed total finance receivables of $599 million ($533 million at December
31, 2003), of which $522 million had been sold to the special purpose subsidiary
($458 million at December 31, 2003). The special purpose subsidiary then in turn
sold loans, with recourse to the special purpose subsidiary, of $370 million to
the bank conduit facility at June 30, 2004 ($334 million at December 31, 2003)
leaving $229 million of finance receivables recorded on our consolidated balance
sheet at June 30, 2004 ($199 million at December 31, 2003). Proceeds from the
revolving sale of receivables to the bank conduit facility were used to fund new
loans to customers. AFC and the special purpose subsidiary must maintain certain
financial covenants including, among others, limits on the amount of debt AFC
can incur, minimum levels of tangible net worth, and termination events tied to
the performance of the finance receivables portfolio. The securitization
agreement also incorporates the financial covenants of ADESA's new credit
facility. AFC has historically performed better than the covenant thresholds set
forth in the securitization agreement, and we are not aware of any changing
circumstances that would put AFC or us in noncompliance with the covenants
therein.
ACCOUNTING FOR STOCK-BASED COMPENSATION. We have elected to account for
stock-based compensation in accordance with APB Opinion No. 25, "Accounting for
Stock Issued to Employees." Accordingly, we recognize expense for performance
share awards granted and do not recognize expense for employee stock options
granted. The after-tax expense recognized for performance share awards was
approximately $0.8 million for the first six months of 2004 ($1.4 million for
the first six months of 2003). The following table illustrates the effect on net
income and earnings per share if we had applied the fair value recognition
provisions of SFAS 123, "Accounting for Stock-Based Compensation."
QUARTER ENDED SIX MONTHS ENDED
EFFECT OF SFAS 123 JUNE 30, JUNE 30,
ACCOUNTING FOR STOCK-BASED COMPENSATION 2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------------
Millions Except Per Share Amounts
Net Income
As Reported $34.7 $44.4 $87.2 $88.7
Less: Employee Stock Compensation Expense
Determined Under SFAS 123 - Net of Tax 0.1 0.1 0.2 0.2
- -------------------------------------------------------------------------------------------------------------------
Pro Forma Net Income $34.6 $44.3 $87.0 $88.5
- -------------------------------------------------------------------------------------------------------------------
Basic Earnings Per Share
As Reported $0.41 $0.54 $1.03 $1.08
Pro Forma $0.41 $0.54 $1.03 $1.07
Diluted Earnings Per Share
As Reported $0.40 $0.53 $1.02 $1.07
Pro Forma $0.40 $0.53 $1.02 $1.07
- -------------------------------------------------------------------------------------------------------------------
In the previous table, the expense for employee stock options granted determined
under SFAS 123 was calculated using the Black-Scholes option pricing model and
the following assumptions:
2004 2003
- -------------------------------------------------------------------------------------------------------------------
Risk-Free Interest Rate 3.3% 3.1%
Expected Life - Years 5 5
Expected Volatility 28.1% 25.2%
Dividend Growth Rate 2% 2%
- -------------------------------------------------------------------------------------------------------------------
RESTRICTED CASH. Our Automotive Services business had $155.8 million of
restricted cash at June 30, 2004 primarily consisting of funds held in escrow
for the redemption of certain debt in August 2004. (See Note 7.)
9 ALLETE Second Quarter 2004 Form 10-Q
NOTE 2. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NEW ACCOUNTING STANDARDS. In May 2004 the FASB issued FASB Staff Position (FSP)
106-2, "Accounting and Disclosure Requirements Related to the Medicare
Prescription Drug, Improvement and Modernization Act of 2003" (Act), which
provides accounting and disclosure guidance for employers that sponsor
postretirement health care plans that provide prescription drug benefits. FSP
106-2 requires that the Accumulated Postretirement Benefit Obligation and
Postretirement Benefit Cost reflect the impact of the Act upon adoption, which
is required for the first interim period beginning after June 15, 2004. We
provide postretirement health benefits that include prescription drug benefits,
and expect our postretirement prescription drug benefits to qualify us for the
federal subsidy to be provided for under the Act. We expect that the federal
subsidy will reduce our postretirement benefit cost by approximately $2 million
pretax annually. We will adopt FSP 106-2 in the third quarter of 2004.
NOTE 3. SPIN-OFF AND IPO OF AUTOMOTIVE SERVICES
In October 2003 our Board of Directors approved a plan to spin off to ALLETE
shareholders our Automotive Services business as a publicly traded company doing
business as ADESA, Inc. In March 2004 our Board of Directors approved an IPO of
less than 20 percent of all ADESA common stock outstanding. On June 21, 2004
ADESA issued 6.3 million shares of common stock through an IPO priced at $24.00
per share. This represented 6.6 percent of ADESA's 94.9 million shares
outstanding. As a result of the IPO, ALLETE recorded a $73.1 million increase to
Common Stock with no gain being recognized. We will account for the 6.6 percent
public ownership of ADESA as a minority interest. We will continue to own and
consolidate the remaining portion of ADESA until the completion of the spin-off.
The spin-off is expected to take the form of a tax-free stock dividend to
ALLETE's shareholders, who would receive a pro rata number of shares of ADESA
common stock for each share of ALLETE common stock that they own. The spin-off
is subject to the approval of the final plan by ALLETE's Board of Directors,
favorable market conditions, receipt of tax opinions and other customary
conditions. ALLETE's Board of Directors is expected to meet in late August 2004
to finalize details of the spin-off of Automotive Services, which is expected to
be completed by the end of September 2004.
In accordance with SFAS 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," we will report the Automotive Services business in
discontinued operations after the spin-off. For the quarter and six months ended
June 30, 2004, $0.3 million of minority interest expense was included in
Automotive and Investment Operations Expenses on our consolidated statement of
income.
NOTE 4. DISCONTINUED OPERATIONS
During 2003, we sold, under condemnation or imminent threat of condemnation,
substantially all of our water assets in Florida for a total sales price of
approximately $445 million. Earnings from Discontinued Operations for 2003
included a $71.6 million, or $0.86 per share, after-tax gain on the sale of
substantially all our Water Services businesses ($0.2 million first quarter;
$0.2 million second quarter; $3.0 million, or $0.04 per share, third quarter;
$68.2 million, or $0.82 per share, fourth quarter). The gain was net of all
selling, transaction and employee termination benefit expenses, as well as
impairment losses on certain remaining assets.
In June 2004 we essentially concluded our strategy to exit our Water Services
businesses when we completed the sales of our North Carolina water assets and
the sale of the remaining 72 water and wastewater systems in Florida. Aqua
America purchased our North Carolina water assets for $48 million and the
assumption of approximately $28 million in debt, and also purchased 63 of our
water and wastewater systems in Florida for $14 million. Seminole County
purchased the remaining 9 Florida systems for a total of $4 million. The
transactions related to the sale of our remaining water systems in Florida are
subject to regulatory approval by the FPSC. The approval process may result in
an adjustment to the final purchase price based on the FPSC's determination of
plant investment for the systems. Earnings from Discontinued Operations for 2004
included a $5.4 million, or $0.06 per share, after-tax gain on the sale of North
Carolina water assets and remaining water and wastewater systems in Florida
($0.4 million of after-tax expenses first quarter and $5.8 million, or $0.06 per
share, net gain second quarter).
The net cash proceeds from the sale of all water assets in 2003 and 2004, after
transaction costs, retirement of most Florida Water debt and payment of income
taxes, were approximately $300 million. These net proceeds were used to retire
debt at ALLETE. We expect to sell our water assets in Georgia in the second half
of 2004.
ALLETE Second Quarter 2004 Form 10-Q 10
NOTE 4. DISCONTINUED OPERATIONS (Continued)
In October 2003 the FPSC voted to initiate an investigation into the ratemaking
considerations of the gain on sale of Florida Water's assets, and whether gains
should be shared with the previous customers of Florida Water. In June 2004
Florida enacted legislation which provides that gains or losses resulting from
the purchase or condemnation of a utility's assets, which results in the loss of
customers and revenue served by such assets, are to be borne by the shareholders
of the utility. This applies to all transactions prior to and after the
effective date of the new law.
SUMMARY OF DISCONTINUED OPERATIONS
- -------------------------------------------------------------------------------------------------------------------------
Millions
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
INCOME STATEMENT 2004 2003 2004 2003
- -------------------------------------------------------------------------------------------------------------------------
Operating Revenue $7.6 $31.2 $15.2 $62.1
- -------------------------------------------------------------------------------------------------------------------------
Pre-Tax Income (Loss) from Operations $0.2 $11.5 $(0.2) $19.4
Income Tax Expense 0.2 4.4 - 7.5
- -------------------------------------------------------------------------------------------------------------------------
- 7.1 (0.2) 11.9
- -------------------------------------------------------------------------------------------------------------------------
Gain on Disposal 8.7 0.4 8.1 3.1
Income Tax Expense 6.9 0.2 6.7 1.4
- -------------------------------------------------------------------------------------------------------------------------
1.8 0.2 1.4 1.7
- -------------------------------------------------------------------------------------------------------------------------
Income from Discontinued Operations $1.8 $7.3 $1.2 $13.6
- -------------------------------------------------------------------------------------------------------------------------
JUNE 30, DECEMBER 31,
BALANCE SHEET INFORMATION 2004 2003
- -------------------------------------------------------------------------------------------------------------------------
Assets of Discontinued Operations
Cash and Cash Equivalents $ 8.5 $ 6.5
Other Current Assets 1.1 8.4
Property, Plant and Equipment 6.0 81.2
Other Assets 2.2 6.7
- -------------------------------------------------------------------------------------------------------------------------
$17.8 $102.8
- -------------------------------------------------------------------------------------------------------------------------
Liabilities of Discontinued Operations
Current Liabilities $15.0 $49.5
Long-Term Debt - 19.9
Other Liabilities 2.7 25.1
- -------------------------------------------------------------------------------------------------------------------------
$17.7 $94.5
- -------------------------------------------------------------------------------------------------------------------------
Included $6.6 million of accrued charges related to our vehicle import business. (See ADESA Importation Litigation.)
Included a $2.0 million recovery from a settlement related to the 2002 sale of our vehicle transport business.
ADESA IMPORTATION LITIGATION. In 2002 a former employee of ADESA Importation,
our vehicle import business, which we exited in the first quarter of 2003, filed
suit against ADESA and ADESA Importation alleging breach of contract and breach
of other oral agreements related to ADESA Importation's purchase of
International Vehicle Importers, Inc. in December 2000. ADESA Importation filed
a counterclaim against the former employee including allegations of a number of
improper acts by the employee including breach of contract, breach of fiduciary
duty and fraud. Pursuant to Michigan law, the case was originally evaluated by a
three attorney panel. During the mandatory case evaluation process, the three
attorney panel awarded the former employee damages of $153,000. At the same
time, the panel awarded ADESA and ADESA Importation damages of $225,000 for its
counterclaims. The former employee rejected the panel's decision resulting in a
jury trial. On June 1, 2004 a jury awarded damages of $5.8 million to the former
employee related to the allegation that ADESA breached oral agreements to
provide funding to ADESA Importation. The jury also found in favor of ADESA and
ADESA Importation on three of its counterclaims including breach of contract,
breach of fiduciary duty and fraud and awarded ADESA and ADESA Importation
$69,000. ADESA and ADESA Importation believe that they have valid grounds for
appeal in this matter and intend to appeal the jury award, seeking reversal of
the verdict or a new trial. Post-trial motions were filed with the trial court
in July 2004. In prior periods ADESA did not accrue an amount for this matter,
based upon the finding of the three attorney panel during the case evaluation.
As a result of the jury trial verdict, ADESA accrued $6.6 million ($4.0 million
after taxes) for the jury award plus interest and legal fees in the second
quarter of 2004 as a loss from discontinued operations.
11 ALLETE Second Quarter 2004 Form 10-Q
NOTE 5. INVESTMENTS
At June 30, 2004 Investments included the real estate assets of ALLETE
Properties, debt and equity securities consisting primarily of $45.0 million of
securities held for employee benefits ($41.4 million at December 31, 2003) and
$34.5 million of economic development revenue bonds held by ADESA in conjunction
with a capital lease of a vehicle auction facility in Georgia ($34.5 million at
December 31, 2003), and our emerging technology investments.
JUNE 30, DECEMBER 31,
INVESTMENTS 2004 2003
- ---------------------------------------------------------------------------------------------------------------------
Millions
Real Estate Assets $ 76.1 $ 78.5
Debt and Equity Securities 81.6 88.6
Emerging Technology Investments 26.9 37.5
- ---------------------------------------------------------------------------------------------------------------------
$ 184.6 $ 204.6
- ---------------------------------------------------------------------------------------------------------------------
We account for our emerging technology investments under the cost method, and
review for impairment on a quarterly basis. During the second quarter of 2004 we
recorded $7.9 million ($4.7 million after taxes) of impairment losses primarily
related to direct investments in certain privately-held start-up companies whose
future business prospects have diminished significantly. Recent developments at
these companies indicate that future commercial viability is unlikely, as is new
financing necessary to continue development.
Our total carrying value of $26.9 million at June 30, 2004 included $20.4
million for investments in three venture capital funds that have a current fund
reported value of approximately $10 million. The venture capital funds invest in
many privately-held start-up companies, and generally value the investments at
the most recent round of equity financing with failed investments written down
to zero. Experience indicates that failures in the fund's portfolio emerge early
while successful companies tend to take longer to materialize. In addition, the
most recent round of equity financing may produce a low valuation as it would
not reflect subsequent positive developments occurring at the various companies
in which the funds have invested. Based on our evaluation of these three venture
capital funds, we anticipate that the funds' future value will exceed our
carrying value as successful companies emerge and become fully valued. We have
the ability and intent to hold our investment in these venture capital funds for
a reasonable period of time sufficient for the forecasted valuation to be
realized. As such, we did not consider these venture capital fund investments to
be other-than-temporarily impaired at June 30, 2004.
NOTE 6. GOODWILL AND OTHER INTANGIBLES
We conduct our annual goodwill impairment testing in the second quarter of each
year and the 2004 test resulted in no impairment. No event or change has
occurred that would indicate the carrying amount has been impaired since our
annual test.
GOODWILL
- --------------------------------------------------------------------------------------------------------------------
Millions
Carrying Value, December 31, 2003 $511.0
Acquired during Year -
Change due to Foreign Currency Translation Adjustment (1.5)
- --------------------------------------------------------------------------------------------------------------------
Carrying Value, June 30, 2004 $509.5
- --------------------------------------------------------------------------------------------------------------------
JUNE 30, DECEMBER 31,
OTHER INTANGIBLE ASSETS 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Millions
Customer Relationships $ 29.6 $ 29.6
Computer Software 29.1 28.1
Other 5.5 5.7
Accumulated Amortization (33.5) (30.1)
- --------------------------------------------------------------------------------------------------------------------
$ 30.7 $ 33.3
- --------------------------------------------------------------------------------------------------------------------
Other Intangible Assets are amortized using the straight-line method.
Amortization periods are seven to twenty-five years for Customer Relationships,
one to seven years for Computer Software and three to ten years for Other.
ALLETE Second Quarter 2004 Form 10-Q 12
NOTE 7. LONG-TERM DEBT
JUNE 30, DECEMBER 31,
LONG-TERM DEBT 2004 2003
- --------------------------------------------------------------------------------------------------------------------
Millions
ALLETE
First Mortgage Bonds
6.68% Series Due 2007 $ 20.0 $ 20.0
7% Series Due 2007 60.0 60.0
7 1/2% Series Due 2007 35.0 35.0
7% Series Due 2008 50.0 50.0
6% Pollution Control Series E Due 2022 111.0 111.0
Senior Notes, 7.80% Due 2008 125.0 125.0
Variable Demand Revenue Refunding Bonds
Series 1997 A, B, C and D Due 2007 - 2020 39.0 39.0
Industrial Development Revenue Bonds 6.5% Due 2025 35.1 35.1
Other Long-Term Debt, 1.1% - 8.8% Due 2004 - 2025 76.2 75.2
- --------------------------------------------------------------------------------------------------------------------
551.3 550.3
Less Due Within One Year 159.0 35.6
- --------------------------------------------------------------------------------------------------------------------
392.3 514.7
- --------------------------------------------------------------------------------------------------------------------
Automotive Services (ADESA)
Variable Term Loan A Facility Due 2009 175.0 -
Variable Term Loan B Facility Due 2010 100.0 -
Senior Notes
7.70% Series A Due 2006 90.0 90.0
8.10% Series B Due 2010 35.0 35.0
Senior Subordinated Notes 7 5/8% Series Due 2012 125.0 -
Variable Notes
Due 2006 - 45.0
Due 2020 - 28.4
Capital Lease Obligation 34.5 34.5
Other Long-Term Debt, 6% Due 2004 - 2005 0.2 2.0
- --------------------------------------------------------------------------------------------------------------------
559.7 234.9
Less Due Within One Year 161.1 1.9
- --------------------------------------------------------------------------------------------------------------------
398.6 233.0
- --------------------------------------------------------------------------------------------------------------------
Net Long-Term Debt $790.9 $747.7
- --------------------------------------------------------------------------------------------------------------------
Excluded Automotive Services.
In January 2004 ALLETE used internally generated funds to retire approximately
$3.5 million in principal amount of Industrial Development Revenue Bonds Series
1994-A, due January 1, 2004.
In June 2004 ALLETE called $125 million in principal amount of 7.80% Senior
Notes due 2008. Proceeds from the sale of our water assets and proceeds received
from ADESA were used to repay this debt on July 26, 2004. As a result of the
redemption, we recognized an expense of $18.5 million in the third quarter of
2004 comprised of an early redemption premium and the write-off of unamortized
debt issuance costs. We have accounted for this debt as due within one year in
the table above.
In July 2004 ALLETE called, for redemption in August 2004, $111 million in
principal amount of Collateralized 6% Pollution Control Refunding Revenue Bonds
Series E due 2022 and expects to refinance these bonds in August 2004 at a more
favorable interest rate.
In June 2004 ADESA substantially completed the restructuring of debt in
conjunction with its June IPO and planned spin-off from ALLETE. In June 2004
ADESA issued $125 million of 7 5/8% Senior Subordinated Notes at par with a
maturity date of June 15, 2012, borrowed $275 million under a new $525 million
credit facility, and repaid $75.1 million of previously existing debt and all
intercompany debt outstanding to ALLETE. In July 2004 ADESA called for
redemption all of its $90 million in principal amount of 7.70% Senior Notes due
2006 and all of its $35 million in principal amount of 8.10% Senior Notes due
2010. The redemptions are scheduled to occur on August 11, 2004, and ADESA
expects to recognize expenses of approximately $14 million in the third quarter
comprised of an early redemption premium and the write-off of unamortized debt
issuance costs. We have accounted for the $125 million of debt to be redeemed by
ADESA as due within one year in the table above.
13 ALLETE Second Quarter 2004 Form 10-Q
NOTE 7. LONG-TERM DEBT (CONTINUED)
ADESA's new credit facility contains customary affirmative and negative
covenants, including restrictions on the ability to incur indebtedness, grant
liens, pay dividends or make distributions to shareholders and make any
prepayment or redemption with respect to the senior subordinated notes. The new
credit facility also contains financial covenants including: a maximum total
leverage ratio, a minimum interest coverage ratio and a minimum fixed charge
coverage ratio. At June 30, 2004, ADESA was in compliance with the covenants
contained in the new credit facility.
In June 2004 ADESA entered into two interest rate swap agreements with notional
amounts of $105 million and $60 million to manage its exposure to interest rate
movements on its variable rate debt. Both interest rate swap agreements contain
amortizing provisions and mature in December 2006. ADESA has designated its
interest rate swap agreements as cash flow hedges. The fair value of the
interest rate swap agreements is estimated using pricing models widely used in
financial markets and represents the estimated amount ADESA would receive or pay
to terminate the agreement at the reporting date. At June 30, 2004 the fair
value of the interest rate swap agreements is an unrealized loss of $0.6 million
and is recorded in accrued expenses and other liabilities on the consolidated
balance sheet. In accordance with the provisions of SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities," changes in the fair value of the
interest rate swap agreements designated as cash flow hedges are recorded in
Accumulated Other Comprehensive Income. ADESA is exposed to credit loss in the
event of nonperformance by the counterparties; however, nonperformance is not
anticipated.
NOTE 8. SHORT-TERM BORROWINGS
In April 2004 ALLETE used internally generated funds and proceeds from the sale
of water assets to repay the remaining $53.0 million outstanding on a $250
million credit agreement which would have expired in July 2004.
NOTE 9. PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS
POSTRETIREMENT HEALTH
PENSION AND LIFE
------------------------ ----------------------
COMPONENTS OF PERIODIC BENEFIT EXPENSE 2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------
Millions
FOR THE QUARTER ENDED JUNE 30,
Service Cost $ 2.1 $ 1.7 $1.1 $ 0.9
Interest Cost 5.2 4.9 1.8 1.7
Expected Return on Plan Assets (6.9) (7.2) (1.1) (1.0)
Amortization of Prior Service Costs 0.2 0.2 - -
Amortization of Net Loss 0.4 - 0.3 -
Amortization of Transition Obligation - - 0.6 0.6
- ------------------------------------------------------------------------------------------------------------------
Periodic Benefit Expense (Benefit) $ 1.0 $(0.4) $2.7 $ 2.2
- ------------------------------------------------------------------------------------------------------------------
FOR THE SIX MONTHS ENDED JUNE 30,
Service Cost $ 4.2 $ 3.4 $2.2 $1.8
Interest Cost 10.4 9.8 3.6 3.4
Expected Return on Plan Assets (13.8) (14.4) (2.2) (2.0)
Amortization of Prior Service Costs 0.4 0.4 - -
Amortization of Net Loss 0.8 - 0.5 -
Amortization of Transition Obligation 0.1 0.1 1.2 1.2
- ------------------------------------------------------------------------------------------------------------------
Periodic Benefit Expense (Benefit) $ 2.1 $(0.7) $5.3 $4.4
- ------------------------------------------------------------------------------------------------------------------
ALLETE Second Quarter 2004 Form 10-Q 14
NOTE 10. INCOME TAX EXPENSE
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------
Millions
Current Tax Expense
Federal $16.2 $15.3 $38.3 $31.9
Foreign 4.1 7.3 7.8 9.2
State 3.0 2.3 8.0 6.0
- ------------------------------------------------------------------------------------------------------------------
23.3 24.9 54.1 47.1
- ------------------------------------------------------------------------------------------------------------------
Deferred Tax Expense
Federal 0.5 0.2 4.1 2.4
State 0.2 0.1 0.5 0.5
- ------------------------------------------------------------------------------------------------------------------
0.7 0.3 4.6 2.9
- ------------------------------------------------------------------------------------------------------------------
Deferred Tax Credits (0.2) (0.2) (0.8) (0.6)
- ------------------------------------------------------------------------------------------------------------------
Income Tax Expense on Continuing Operations 23.8 25.0 57.9 49.4
Income Tax Expense on Discontinued Operations 7.1 4.6 6.7 8.9
- ------------------------------------------------------------------------------------------------------------------
Total Income Tax Expense $30.9 $29.6 $64.6 $58.3
- ------------------------------------------------------------------------------------------------------------------
NOTE 11. EARNINGS PER SHARE
The difference between basic and diluted earnings per share arises from
outstanding stock options and performance share awards granted under our
Executive and Director Long-Term Incentive Compensation Plans.
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------- -------------------------------
RECONCILIATION OF BASIC AND DILUTED DILUTIVE DILUTIVE
EARNINGS PER SHARE BASIC SECURITIES DILUTED BASIC SECURITIES DILUTED
- --------------------------------------------------------------------------------------------------------------------
Millions
2004
Net Income from Continuing Operations $32.9 - $32.9 $86.0 - $86.0
Common Shares 85.1 0.5 85.6 84.7 0.5 85.2
Per Share from Continuing Operations $0.39 - $0.38 $1.02 - $1.01
2003
Net Income from Continuing Operations $37.1 - $37.1 $75.1 - $75.1
Common Shares 82.6 0.3 82.9 82.4 0.2 82.6
Per Share from Continuing Operations $0.45 - $0.45 $0.91 - $0.91
- --------------------------------------------------------------------------------------------------------------------
NOTE 12. COMPREHENSIVE INCOME
For the quarter ended June 30, 2004 total comprehensive income was $30.7 million
($66.3 million for the quarter ended June 30, 2003). For the six months ended
June 30, 2004 total comprehensive income was $81.1 million ($122.9 million for
the six months ended June 30, 2003). Total comprehensive income includes net
income, unrealized gains and losses on securities classified as
available-for-sale and interest rate swaps, additional pension liability and
foreign currency translation adjustments.
JUNE 30, DECEMBER 31,
ACCUMULATED OTHER COMPREHENSIVE GAIN 2004 2003
- ------------------------------------------------------------------------------------------------------------------
Millions
Unrealized Gain on Securities $ 1.1 $ 0.8
Interest Rate Swaps (0.3) -
Foreign Currency Translation Gain 17.4 23.5
Additional Pension Liability (9.8) (9.8)
- ------------------------------------------------------------------------------------------------------------------
$ 8.4 $14.5
- ------------------------------------------------------------------------------------------------------------------
15 ALLETE Second Quarter 2004 Form 10-Q
NOTE 13. COMMITMENTS, GUARANTEES AND CONTINGENCIES
SQUARE BUTTE POWER PURCHASE AGREEMENT. Minnesota Power has a power purchase
agreement with Square Butte that extends through 2026 (Agreement). It provides a
long-term supply of low-cost energy to customers in our electric service
territory and enables Minnesota Power to meet power pool reserve requirements.
Square Butte, a North Dakota cooperative corporation, owns a 455-MW coal-fired
generating unit (Unit) near Center, North Dakota. The Unit is adjacent to a
generating unit owned by Minnkota Power, a North Dakota cooperative corporation
whose Class A members are also members of Square Butte. Minnkota Power serves as
the operator of the Unit and also purchases power from Square Butte.
Minnesota Power is entitled to approximately 71 percent of the Unit's output
under the Agreement. After 2005 and upon compliance with a two-year advance
notice requirement, Minnkota Power has the option to reduce Minnesota Power's
entitlement by 5 percent annually, to a minimum of 50 percent. In December 2003
we received notice from Minnkota Power that they will reduce our output
entitlement, effective January 1, 2006, by 5 percent to approximately 66
percent. Minnesota Power is obligated to pay its pro rata share of Square
Butte's costs based on Minnesota Power's entitlement to Unit output. Minnesota
Power's payment obligation shall be suspended if Square Butte fails to deliver
any power, whether produced or purchased, for a period of one year. Square
Butte's fixed costs consist primarily of debt service. At June 30, 2004 Square
Butte had total debt outstanding of $287.7 million. Total annual debt service
for Square Butte is expected to be approximately $23 million in each of the
years 2004 through 2008. Variable operating costs include the price of coal
purchased from BNI Coal, our subsidiary, under a long-term contract. Minnesota
Power's payments to Square Butte are approved as a purchased power expense for
ratemaking purposes by both the MPUC and the FERC.
LEASING AGREEMENTS. We lease properties and equipment under operating lease
agreements with terms expiring through 2019. The aggregate amount of minimum
lease payments for all operating leases during 2004 is $19.9 million ($16.1
million in 2005; $13.6 million in 2006; $6.5 million in 2007; $5.9 million in
2008; and $49.5 million thereafter). Automotive Services' portion of these
minimum lease payments is $18.8 million in 2004 ($15.2 million in 2005; $12.7
million in 2006; $5.9 million in 2007; $5.6 million in 2008; and $48.8 million
thereafter).
KENDALL COUNTY POWER PURCHASE AGREEMENT. We have 275 MW of nonregulated
generation (non rate-base generation sold at market-based rates to the wholesale
market) through an agreement with a wholly owned subsidiary of NRG Energy that
extends through September 2017. Under the agreement we pay a fixed capacity
charge for the right, but not the obligation, to capacity and energy from a 275
MW generating unit at NRG Energy's Kendall County facility near Chicago,
Illinois. The annual fixed capacity charge is approximately $21 million. We are
also responsible for arranging the natural gas fuel supply. Our strategy is to
enter into long-term contracts to sell a significant portion of the 275 MW from
the Kendall County facility; the balance will be sold in the spot market through
short-term agreements. We currently have 130 MW (100 MW in 2003) of long-term
capacity sales contracts for the Kendall County generation, with 50 MW expiring
in April 2012 and 80 MW expiring in September 2017. Neither the Kendall County
agreement nor the related sales contracts are derivatives under SFAS 133,
"Accounting for Derivative Instruments and Hedging Activities." To date, the
Kendall County facility has operated at a loss due to negative spark spreads
(the differential between electric and natural gas prices) in the wholesale
power market and our resulting inability to cover the fixed capacity charge on
unsold capacity (currently 145 MW). We expect the facility to continue to
generate losses until such time as spark spreads improve or we are able to enter
into additional long-term capacity sales contracts. We are currently exploring
options to minimize or eliminate these ongoing losses. We are utilizing Tenaska
Power Services Company to provide operational and scheduling services for the
Kendall County generating unit.
COAL AND SHIPPING CONTRACTS. We have three coal supply agreements with various
expiration dates ranging from December 2006 to December 2009. We also have rail
and shipping agreements for transportation of all of our coal with various
expiration dates ranging from December 2005 to December 2011. Our minimum annual
obligation under these coal and shipping agreements range from approximately $28
million in 2004 to $10 million in 2008.
EMERGING TECHNOLOGY INVESTMENTS. We have investments in emerging technologies
through minority investments in venture capital funds and direct investments in
privately-held start-up companies. We have committed to make additional
investments in certain emerging technology holdings. The total future commitment
was $4.7 million at June 30, 2004 ($4.8 million at December 31, 2003) and is
expected to be invested at various times through 2007.
ALLETE Second Quarter 2004 Form 10-Q 16
NOTE 13. COMMITMENTS, GUARANTEES AND CONTINGENCIES (CONTINUED)
ENVIRONMENTAL MATTERS. Our businesses are subject to regulation by various U.S.
and Canadian federal, state, provincial and local authorities concerning
environmental matters. We do not currently anticipate that potential
expenditures for environmental matters will be material; however, we are unable
to predict the outcome of the issues discussed below.
We review environmental matters on a quarterly basis. Accruals for environmental
matters are recorded when it is probable that a liability has been incurred and
the amount of the liability can be reasonably estimated, based on current law
and existing technologies. These accruals are adjusted periodically as
assessment and remediation efforts progress or as additional technical or legal
information becomes available. Accruals for environmental liabilities are
included in the balance sheet at undiscounted amounts and exclude claims for
recoveries from insurance or other third parties. Costs related to environmental
contamination treatment and cleanup are charged to expense unless recoverable in
rates from customers.
SWL&P MANUFACTURED GAS PLANT. In May 2001 SWL&P received notice from the WDNR
that the City of Superior had found soil contamination on property adjoining a
former Manufactured Gas Plant (MGP) site owned and operated by SWL&P from 1889
to 1904. The WDNR requested SWL&P to initiate an environmental investigation.
The WDNR also issued SWL&P a Responsible Party letter in February 2002. The
environmental investigation is underway. In February 2003 SWL&P submitted a
Phase II environmental site investigation report to the WDNR. This report
identified some MGP-like chemicals that were found in the soil near the former
plant site. During March and April 2003 sediment samples were taken from nearby
Superior Bay. The report on the results of this sampling was completed and sent
to the WDNR during the first quarter of 2004. The next phase of the
investigation will be to determine any impact to soil or ground water between
the former MGP site and Superior Bay. A work plan for this additional
investigation by SWL&P was filed in December 2003 with the WDNR. Permission from
landowners is currently being obtained to perform the additional tests. Although
it is not possible to quantify the potential clean-up cost until the
investigation is completed and a work plan is developed, a $0.5 million
liability was recorded in December 2003 to address the known areas of
contamination. We have recorded a corresponding dollar amount as a regulatory
asset to offset this liability. The PSCW has approved SWL&P's deferral of these
MGP environmental investigation and potential clean-up costs for future recovery
in rates, subject to regulatory prudency review.
MINNESOTA POWER COAL-FIRED GENERATING FACILITIES. During 2002 Minnesota Power
received and responded to a third request from the EPA, under Section 114 of the
federal Clean Air Act Amendments of 1990 (Clean Air Act), seeking additional
information regarding capital expenditures at all of its coal-fired generating
stations. This action is part of an industry-wide investigation assessing
compliance with the New Source Review and the New Source Performance Standards
(emissions standards that apply to new and changed units) of the Clean Air Act
at electric generating stations. We have received no feedback from the EPA based
on the information we submitted. There is, however, ongoing litigation involving
the EPA and other electric utilities for alleged violations of these rules. It
is expected that the outcome of some of the cases could provide the utility
industry direction on this topic. We are unable to predict what actions, if any,
may be required as a result of the EPA's request for information. As a result,
we have not accrued any liability for this environmental matter.
SQUARE BUTTE GENERATING FACILITY. In June 2002 Minnkota Power, the operator of
Square Butte, received a Notice of Violation from the EPA regarding alleged New
Source Review violations at the M.R. Young Station which includes the Square
Butte generating unit. The EPA claims certain capital projects completed by
Minnkota Power should have been reviewed pursuant to the New Source Review
regulations potentially resulting in new air permit operating conditions.
Minnkota Power has held several meetings with the EPA to discuss the alleged
violations. Based on an EPA request, Minnkota Power performed a study related to
the technological feasibility of installing various controls for the reduction
of nitrogen oxides and sulfur dioxide emissions. Discussions with the EPA are
ongoing and we are unable to predict the outcome or cost impacts. If Square
Butte is required to make significant capital expenditures to comply with EPA
requirements, we expect such capital expenditures to be debt financed. Our
future cost of purchased power would include our pro rata share of this
additional debt service.
17 ALLETE Second Quarter 2004 Form 10-Q
NOTE 13. COMMITMENTS, GUARANTEES AND CONTINGENCIES (CONTINUED)
ADESA IMPACT TAUNTON FACILITY. In December 2003 the Massachusetts Department of
Environmental Protection (MDEP) identified ADESA as a potentially responsible
party regarding contamination of several private drinking water wells in a
residential development that abuts the Taunton, Massachusetts salvage auction
facility. The wells had elevated levels of MTBE. MTBE is an oxygenating additive
in gasoline to reduce harmful emissions. The EPA has identified MTBE as a
possible carcinogen. ADESA engaged GeoInsight, an environmental services firm,
to conduct tests of the soil and groundwater at the salvage vehicle auction
site.
In December 2003 GeoInsight collected soil samples, conducted groundwater tests
and provided oversight for the installation of monitoring wells in various
locations on and adjacent to the property adjoining the residential community.
The results of the soil and water tests indicated levels of MTBE exceeding MDEP
standards. In January 2004 GeoInsight collected air samples from two residences
that were identified as having elevated drinking water concentrations of MTBE.
ADESA has determined that inhalation of, or contact exposure to, this air poses
minimal risk to human health. In response to its empirical findings, ADESA
proposed to the MDEP that we install water filtration units in the approximately
33 affected residences. Thirty-two units have been installed.
GeoInsight prepared an immediate response action (IRA) plan, which was required
by the MDEP, to determine the extent of the environmental impact and define
activities to prevent further environmental contamination. The IRA plan, which
was filed in January 2004, describes the initial activities ADESA performed, and
proposes additional measures that it will use to further assess the existence of
any imminent hazard to human health. In addition, as required by the MDEP, ADESA
has conducted an analysis to identify sensitive receptors that may have been
affected, including area schools and municipal wells. GeoInsight does not
believe that an imminent hazard condition exists at the Taunton site; however,
the investigation and assessment of site conditions are ongoing.
ADESA submitted an IRA plan status report to the MDEP in March 2004.
Additionally, ADESA is submitting bi-weekly status updates to the MDEP. A
comprehensive ground water sampling event and residential sampling event were
conducted in April 2004. ADESA's representatives met with the Taunton City
Council to propose that ADESA extend municipal water services to the adjoining
residential community at an approximate cost of $1 million. In August 2004 ADESA
expects to present a detailed engineering proposal to the Taunton City Council.
ADESA has an accrual of $1.2 million at June 30, 2004 with respect to this
matter, including the estimated costs (as of June 30, 2004) associated with the
proposal to extend the municipal water service.
ADESA has filed a claim with our insurance carrier with respect to this matter.
On March 30, 2004 our insurance carrier responded with a request for additional
information regarding the claims.
In addition to the activity described above, ADESA has received correspondence
from an attorney representing residents of the adjoining residential community
suggesting that ADESA enter into discussions concerning property damage claims
for diminution in value due to the MTBE release. Accordingly, there is a
possibility that property damage litigation may be filed against ADESA.
Potential losses in these matters are not considered probable by ADESA
management or cannot be reasonably estimated. Accordingly, ADESA has not
recorded an accrual for the respective costs of these matters.
OTHER. We are involved in litigation arising in the normal course of business.
Also in the normal course of business, we are involved in tax, regulatory and
other governmental audits, inspections, investigations and other proceedings
that involve state and federal taxes, safety, compliance with regulations, rate
base and cost of service issues, among other things. While the resolution of
such matters could have a material effect on earnings and cash flows in the year
of resolution, none of these matters are expected to change materially our
present liquidity position, nor have a material adverse effect on our financial
condition.
See Note 4 for a discussion on the ADESA Importation litigation.
ALLETE Second Quarter 2004 Form 10-Q 18
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
ALLETE'S operations are comprised of three business segments. ENERGY SERVICES
includes electric and gas services, coal mining and telecommunications.
AUTOMOTIVE SERVICES, with operations across the United States, Canada and
Mexico, includes wholesale vehicle auctions and related vehicle redistribution
services as well as dealer financing. Auctions and related services include
wholesale used vehicle and salvage vehicle auctions. INVESTMENTS AND CORPORATE
CHARGES includes our Florida real estate operations, investments in emerging
technologies, and general corporate charges and interest not specifically
related to any one business segment. General corporate charges include employee
salaries and benefits as well as legal and other outside service fees.
DISCONTINUED OPERATIONS includes our Water Services businesses, and our vehicle
transport and import businesses.
Through a June 2004 IPO our Automotive Services business, doing business as
ADESA, Inc. (NYSE: KAR), issued 6.3 million shares of common stock at an IPO
price of $24.00 per share. This represented 6.6 percent of total ADESA common
stock outstanding. ALLETE will continue to own the remaining 93.4 percent of
ADESA until the planned spin-off, which is expected to be completed by the end
of September 2004. In connection with the IPO, ADESA filed a registration
statement on Form S-1 with the SEC and also became subject to the reporting
requirements under the Securities Exchange Act of 1934. These documents are
available through the SEC's website at www.sec.gov.
CONSOLIDATED OVERVIEW
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
2004 2003 2004 2003
- ----------------------------------------------------------------------------------------------------------------------
Millions Except Per Share Amounts
Operating Revenue
Energy Services $183.9 $158.5 $366.2 $337.6
Automotive Services 232.1 240.7 479.8 473.6
Investments (0.7) 10.7 27.8 21.6
- ----------------------------------------------------------------------------------------------------------------------
$415.3 $409.9 $873.8 $832.8
- ----------------------------------------------------------------------------------------------------------------------
Operating Expenses
Energy Services $169.3 $147.6 $329.1 $306.7
Automotive Services 178.7 183.9 371.5 372.6
Investments and Corporate Charges 10.6 16.3 29.3 29.0
- ----------------------------------------------------------------------------------------------------------------------
$358.6 $347.8 $729.9 $708.3
- ----------------------------------------------------------------------------------------------------------------------
Net Income (Loss)
Energy Services $ 9.3 $ 6.8 $23.6 $19.0
Automotive Services 32.3 34.1 65.6 60.8
Investments and Corporate Charges (8.7) (3.8) (3.2) (4.7)
- ----------------------------------------------------------------------------------------------------------------------
Continuing Operations 32.9 37.1 86.0 75.1
Discontinued Operations 1.8 7.3 1.2 13.6
- ----------------------------------------------------------------------------------------------------------------------
$34.7 $44.4 $87.2 $88.7
- ----------------------------------------------------------------------------------------------------------------------
Diluted Average Shares of Common Stock - Millions 85.6 82.9 85.2 82.6
- ----------------------------------------------------------------------------------------------------------------------
Diluted Earnings Per Share of Common Stock
Continuing Operations $0.38 $0.45 $1.01 $0.91
Discontinued Operations 0.02 0.08 0.01 0.16
- ----------------------------------------------------------------------------------------------------------------------
$0.40 $0.53 $1.02 $1.07
- ----------------------------------------------------------------------------------------------------------------------
Net income for the quarter and six months ended June 30, 2004 decreased 22
percent and 2 percent, respectively, from the same periods in 2003 and diluted
earnings per share for the quarter and six months ended June 30, 2004 decreased
25 percent and 5 percent, respectively, from the same periods in 2003.
For the quarter ended June 30, 2004 net income and diluted earnings per share
from continuing operations decreased 11 percent and 16 percent, respectively,
from the same period in 2003. For the six months ended June 30, 2004 net income
and diluted earnings per share from continuing operations
19 ALLETE Second Quarter 2004 Form 10-Q
increased 15 percent and 11 percent, respectively, from the same period in 2003.
In 2004 net income reflected a $4.7 million after-tax impairment on our emerging
technology portfolio in the quarter and six months ended June 30, separation
expenses related to the spin-off of ADESA totaling $1.4 million after tax in the
quarter ($3.1 million in the six months ended June 30) and additional corporate
overhead expenses at ADESA of $1.7 million after tax in the quarter ($2.6
million in the six months ended).
NON-GAAP MEASURE OF LIQUIDITY. We believe earnings before interest, taxes,
depreciation and amortization expense (EBITDA) provides meaningful additional
information that helps us monitor and evaluate our ongoing results and trends.
EBITDA should not be considered in isolation nor as a substitute for measures of
liquidity prepared in accordance with GAAP which include:
CONSOLIDATED CASH FLOW
SIX MONTHS ENDED JUNE 30, 2004 2003
- ----------------------------------------------------------------------------------------------------------------------
Millions
Cash from Operating Activities $78.4 $105.5
Cash from (for) Investing Activities $48.4 $(129.6)
Cash from Financing Activities $264.9 $32.8
- ----------------------------------------------------------------------------------------------------------------------
We believe EBITDA is a widely accepted measure of liquidity considered by
investors, financial analysts and rating agencies. EBITDA is not an alternative
to cash flows as a measure of liquidity and may not be comparable with EBITDA as
defined by other companies.
ENERGY SERVICES
----------------------- INVESTMENTS
REGULATED NON- AUTOMOTIVE AND CORPORATE
EBITDA CONSOLIDATED UTILITY REGULATED SERVICES CHARGES
- -------------------------------------------------------------------------------------------------------------------------
FOR THE QUARTER ENDED JUNE 30, 2004
Net Income $34.7
Less: Income from Discontinued Operations 1.8
- -------------------------------------------------------------
Income (Loss) from Continuing Operations 32.9 $ 8.2 $1.1 $32.3 $(8.7)
Add Back: Income Tax Expense (Benefit) 23.8 5.0 0.3 21.1 (2.6)
Interest Expense 13.8 4.6 0.6 4.7 3.9
Depreciation and Amortization Expense 21.3 9.9 2.6 8.8 -
- -------------------------------------------------------------------------------------------------------------------------
EBITDA $91.8 $27.7 $4.6 $66.9 $(7.4)
- -------------------------------------------------------------------------------------------------------------------------
FOR THE QUARTER ENDED JUNE 30, 2003
Net Income $ 44.4
Less: Income from Discontinued Operations 7.3
- -------------------------------------------------------------
Income (Loss) from Continuing Operations 37.1 $ 6.9 $(0.1) $34.1 $(3.8)
Add Back: Income Tax Expense (Benefit) 25.0 4.6 (0.5) 22.7 (1.8)
Interest Expense 16.0 5.0 0.7 3.7 6.6
Depreciation and Amortization Expense 21.9 10.4 2.5 8.9 0.1
- -------------------------------------------------------------------------------------------------------------------------
EBITDA $100.0 $26.9 $ 2.6 $69.4 $ 1.1
- -------------------------------------------------------------------------------------------------------------------------
SIX MONTHS ENDED JUNE 30, 2004
Net Income $ 87.2
Less: Income from Discontinued Operations 1.2
- -------------------------------------------------------------
Income (Loss) from Continuing Operations 86.0 $22.1 $1.5 $ 65.6 $(3.2)
Add Back: Income Tax Expense 57.9 13.3 0.2 42.7 1.7
Interest Expense 26.9 9.3 0.9 8.7 8.0
Depreciation and Amortization Expense 43.0 19.8 5.1 18.1 -
- -------------------------------------------------------------------------------------------------------------------------
EBITDA $213.8 $64.5 $7.7 $135.1 $ 6.5
- -------------------------------------------------------------------------------------------------------------------------
SIX MONTHS ENDED JUNE 30, 2003
Net Income $ 88.7
Less: Income from Discontinued Operations 13.6
- -------------------------------------------------------------
Income (Loss) from Continuing Operations 75.1 $18.3 $ 0.7 $ 60.8 $(4.7)
Add Back: Income Tax Expense (Benefit) 49.4 12.2 (0.3) 40.2 (2.7)
Interest Expense 32.9 10.2 1.1 8.1 13.5
Depreciation and Amortization Expense 42.8 20.7 5.0 17.0 0.1
- -------------------------------------------------------------------------------------------------------------------------
EBITDA $200.2 $61.4 $ 6.5 $126.1 $ 6.2
- -------------------------------------------------------------------------------------------------------------------------
ALLETE Second Quarter 2004 Form 10-Q 20
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
STATISTICAL INFORMATION 2004 2003 2004 2003
- --------------------------------------------------------------------------------------------------------------------
ENERGY SERVICES
Millions of Kilowatthours Sold
Regulated Utility
Retail and Municipals
Residential 228.8 223.9 539.1 536.8
Commercial 294.3 289.6 626.2 616.0
Industrial 1,770.0 1,655.1 3,536.8 3,373.6
Municipals 189.0 204.5 402.8 405.1
Other 17.8 18.3 38.0 38.8
- --------------------------------------------------------------------------------------------------------------------
2,499.9 2,391.4 5,142.9 4,970.3
Other Power Suppliers 168.4 300.8 385.6 508.1
- --------------------------------------------------------------------------------------------------------------------
2,668.3 2,692.2 5,528.5 5,478.4
Nonregulated 414.6 281.1 848.6 700.2
- --------------------------------------------------------------------------------------------------------------------
3,082.9 2,973.3 6,377.1 6,178.6
- --------------------------------------------------------------------------------------------------------------------
AUTOMOTIVE SERVICES
Vehicles Sold
Used 445,000 471,000 926,000 933,000
Salvage 50,000 49,000 108,000 98,000
- --------------------------------------------------------------------------------------------------------------------
495,000 520,000 1,034,000 1,031,000
Conversion Rate - Used Vehicles 61.7% 61.1% 65.0% 61.8%
Loan Transactions 273,000 241,000 536,000 474,000
- --------------------------------------------------------------------------------------------------------------------
Conversion rate is the percentage of vehicles sold from those that were offered at auction.
NET INCOME
The following net income discussion summarizes a comparison of the six months
ended June 30, 2004 to the six months ended June 30, 2003.
ENERGY SERVICES' net income in 2004 was up $4.6 million. At Minnesota Power,
higher retail electric sales contributed to the increase. In addition, despite a
decline in kilowatthour sales to other power suppliers, power marketing margins
improved in 2004 due to the expiration of an unprofitable purchase power
arrangement in 2003.
AUTOMOTIVE SERVICES reported a $4.8 million increase in net income primarily due
to improved margins and a 13 percent increase in loan transactions at AFC. These
increases were partially offset by additional corporate charges and separation
expenses incurred as ADESA prepares to be a stand-alone publicly traded company.
INVESTMENTS AND CORPORATE CHARGES' net loss was $1.5 million lower in 2004
reflecting strong demand for our real estate in Florida and reduced interest
expense. These positive developments were partially offset by an increase in
general corporate charges primarily resulting from $1.5 million of separation
expenses associated with the planned spin-off of Automotive Services and $4.7
million of impairment losses related to our emerging technology portfolio. Net
income from ALLETE Properties, our real estate operations, was up $3.8 million
in 2004 ($13.2 million in 2004; $9.4 million in 2003) primarily due to an
increase in the number as well as the profitability of real estate sales closing
during the first six months of 2004. The timing of real estate sales varies from
quarter to quarter.
DISCONTINUED OPERATIONS included the financial results of the Water Services
businesses, and the vehicle transport and import businesses. We will report our
Automotive Services' business in discontinued operations after the planned
spin-off which is expected in September 2004. Overall, net income from
discontinued operations decreased $12.4 million, primarily because the first six
months of 2003 included $12.8 million from the operations of our Water Services
businesses, the majority of which were sold in the fourth quarter of 2003. The
first six months of 2004 included a $5.4 million gain on the sale of water
assets ($0.4 million for the first six months of 2003). Net income from other
discontinued operations included $4.0 million of charges in 2004 in connection
with a lawsuit related to the vehicle import business and a $1.3 million
recovery in 2003 from the settlement of a lawsuit associated with the vehicle
transport business.
21 ALLETE Second Quarter 2004 Form 10-Q
COMPARISON OF THE QUARTERS ENDED JUNE 30, 2004 AND 2003
ENERGY SERVICES
Regulated utility operations include retail and wholesale rate regulated
activities under the jurisdiction of state and federal regulatory authorities.
Nonregulated operations consist of nonregulated generation (non-rate base
generation sold at market-based rates to the wholesale market), coal mining and
telecommunication activities. Nonregulated generation consists primarily of the
Taconite Harbor Energy Center in northern Minnesota and generation secured
through the Kendall County power purchase agreement, a 15-year agreement with a
wholly owned subsidiary of NRG Energy at a facility near Chicago, Illinois.
OPERATING REVENUE in total was up $25.4 million, or 16 percent, in 2004
reflecting increases at both our regulated utility and nonregulated operations.
Regulated utility revenue was up $11.1 million, or 9 percent, in 2004 primarily
due to higher fuel clause recoveries resulting from increased purchase power
costs (see operating expenses below), and increased retail electric sales. Much
of the increase in retail electric sales was attributable to large power
customers due to higher production levels in 2004. Overall, regulated utility
kilowatthour sales were similar to last year (down 1 percent) as increased sales
to retail customers reduced the energy available for sale to other power
suppliers. An outage at one of the Company's generating units (see Outlook -
Energy Services) also contributed to less energy being available for sale to
other power suppliers. Nonregulated revenue was up $14.3 million, or 44 percent,
in 2004 reflecting a $7.8 million increase in revenue from the Company's
telecommunications business due to more equipment sales and a $4.7 million
increase in revenue from nonregulated generation operations. Nonregulated
kilowatthour sales were up 47 percent in 2004.
Revenue from electric sales to taconite customers accounted for 11 percent of
consolidated operating revenue in 2004 (10 percent in 2003). Electric sales to
paper and pulp mills accounted for 4 percent of consolidated operating revenue
in both 2004 and 2003.
OPERATING EXPENSES in total were up $21.7 million, or 15 percent, in 2004.
Regulated utility operating expenses were up $9.4 million, or 8 percent,
reflecting increased purchased power expense necessitated by an outage at one of
the Company's generating units (see Outlook - Energy Services), and higher
pension and benefit expenses partially offset by the absence of a power
marketing demand payment associated with a purchased power agreement that
expired in 2003. Nonregulated operating expenses were up $12.3 million, or 37
percent, reflecting increased fuel and purchased power expenses, and higher cost
of goods sold associated with increased sales at the Company's
telecommunications business.
AUTOMOTIVE SERVICES
OPERATING REVENUE was down $8.6 million, or 4 percent, in 2004. Revenue from
auctions and related services was down $10.1 million, or 5 percent, primarily
due to decreased vehicle sales volume. The number of vehicles sold at the
Company's vehicle auction facilities decreased 5 percent from last year. The
used vehicle market shift from institutional vehicles to dealer vehicles
continued during the second quarter of 2004 reflecting an anticipated decline in
off-lease vehicles as well as a decline in vehicles repossessed by ADESA's
customers available for redistribution. The decrease in institutional vehicles
available for redistribution was partially offset by an increase in dealer
vehicles sold, a trend that is expected to continue for the remainder of 2004.
Dealer financing revenue was up $1.5 million, or 6 percent, in 2004 reflecting a
13 percent increase in the number of loan transactions. The increase in loan
transactions was a result of an increase in the number of active dealers
combined with an increase in floorplan utilization by the existing dealer base.
OPERATING EXPENSES were down $5.2 million, or 3 percent, in 2004 primarily due
to lower expenses as a result of processing fewer vehicles at our wholesale used
vehicle auctions. The used vehicle market shift from institutional vehicles to
dealer vehicles also contributed to decreased cost of services because dealer
vehicles cost less to process since fewer ancillary services are utilized for
these vehicles as compared to institutional vehicles. This decrease was
partially offset by additional corporate charges of $2.8 million and separation
expenses of $1.4 million incurred as Automotive Services prepared to be a
stand-alone publicly traded company. In addition, interest expense was higher
due to the new debt issued in June 2004.
ALLETE Second Quarter 2004 Form 10-Q 22
INVESTMENTS AND CORPORATE CHARGES
OPERATING REVENUE was down $11.4 million in 2004 primarily due to $7.9 million
($4.7 million after tax) of impairment losses recorded in 2004 related to our
emerging technology portfolio and a $7.4 million decrease in revenue from ALLETE
Properties as a result of fewer land sales. In 2004 one large real estate sale
contributed $2.0 million to revenue, while in 2003 four large real estate sales
contributed $7.9 million to revenue. Revenue in 2003 included $3.5 million of
losses related to the sale of shares the Company held directly in
publicly-traded emerging technology investments.
OPERATING EXPENSES were down $5.7 million, or 35 percent, in 2004 primarily due
to lower interest expense and fewer real estate sales. Operating expenses at
ALLETE Properties were down $2.4 million in 2004 because of fewer land sales.
Interest expense not specifically related to any one business segment decreased
$2.7 million ($3.9 million in 2004; $6.6 million in 2003) due to the redemption
of quarterly income preferred securities and various long-term debt issues in
2003 with both the proceeds from the sale of our Water Services businesses and
internally generated cash.
COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003
ENERGY SERVICES
OPERATING REVENUE in total was up $28.6 million, or 8 percent, in 2004.
Regulated utility revenue was up $14.5 million, or 6 percent, in 2004 primarily
due to higher fuel clause recoveries resulting from increased purchase power
costs (see operating expenses below), and increased retail electric sales. Much
of the increase in retail electric sales was attributable to large power
customers due to higher production levels in 2004. Overall, regulated utility
kilowatthour sales were similar to last year (up 1 percent) as increased sales
to retail customers reduced the energy available for sale to other power
suppliers. An outage at one of the Company's generating units (see Outlook -
Energy Services) also contributed to less energy being available for sale to
other power suppliers. Equity in net income from Split Rock Energy was $5.1
million lower in 2004 as a result of Minnesota Power withdrawing from Split Rock
Energy. Nonregulated revenue was up $14.1 million, or 19 percent, in 2004
reflecting an $8.6 million increase in revenue from the Company's
telecommunications business due to more equipment sales and a $5.1 million
increase in revenue from nonregulated generation operations. Nonregulated
kilowatthour sales were up 21 percent in 2004.
Revenue from electric sales to taconite customers accounted for 10 percent of
consolidated operating revenue in both 2004 and 2003. Electric sales to paper
and pulp mills accounted for 4 percent of consolidated operating revenue in both
2004 and 2003.
OPERATING EXPENSES in total were up $22.4 million, or 7 percent in 2004.
Regulated utility operating expenses were up $9.6 million, or 4 percent,
reflecting increased purchased power expense necessitated by an outage at one of
the Company's generating units (see Outlook - Energy Services), and higher
pension and benefit expenses partially offset by the absence of a power
marketing demand payment associated with a purchased power agreement that
expired in 2003. Nonregulated utility operating expenses were up $12.8 million,
or 17 percent, reflecting increased fuel and purchased power expense, and higher
cost of goods sold associated with increased sales at the Company's
telecommunications business.
AUTOMOTIVE SERVICES
OPERATING REVENUE was up $6.2 million, or 1 percent, in 2004. Revenue from
auctions and related services was up $1.6 million, or less than 1 percent, in
2004 primarily due to a favorable Canadian exchange rate. The number of vehicles
sold at the Company's vehicle auction facilities in total were similar to last
year reflecting fewer institutional vehicles and vehicles repossessed by ADESA's
customers available for redistribution offset by an increase in dealer vehicles
sold. The increase in dealer vehicle demand contributed to an increase in the
number of vehicles sold as a percentage of the number of vehicles entered or
offered for sale at used vehicle auctions. The conversion percentage was 65.0
percent in 2004 (61.8 percent in 2003). Dealer financing revenue was up $4.6
million, or 9 percent, in 2004 reflecting a 13 percent increase in the number of
loan transactions. The increase in loan transactions was a result of an increase
in the number of active dealers combined with an increase in floorplan
utilization by the existing dealer base.
23 ALLETE Second Quarter 2004 Form 10-Q
OPERATING EXPENSES were down $1.1 million, or less than 1 percent, in 2004
primarily due to the impact of the used vehicle market shift towards more dealer
vehicles and higher average used vehicle conversion rates. The used vehicle
market shift from institutional vehicles to dealer vehicles decreased cost of
services in 2004 because dealer vehicles cost less to process since fewer
ancillary services are utilized for these vehicles as compared to institutional
vehicles. This decrease was partially offset by additional corporate charges of
$4.3 million and separation expenses of $2.6 million incurred as Automotive
Services prepared to be a stand-alone publicly traded company. In addition,
interest expense was higher due to the new debt issued in June 2004. Expenses in
2004 also reflected the negative impact of higher Canadian exchange rates in
2004.
INVESTMENTS AND CORPORATE CHARGES
OPERATING REVENUE was up $6.2 million, or 29 percent, in 2004 primarily due to a
$9.3 million increase in revenue from ALLETE Properties as a result of more land
sales. In 2004 11 large real estate sales contributed $22.0 million to revenue,
while in 2003 eight large real estate sales contributed $14.5 million to
revenue. This increase was partially offset by $7.9 million ($4.7 million after
tax) of impairment losses recorded in 2004 related to our emerging technology
portfolio. Revenue in 2003 included $3.5 million of losses related to the sale
of shares the Company held directly in publicly-traded emerging technology
investments.
OPERATING EXPENSES were up slightly in 2004 as more real estate sales and
increased general corporate charges were offset by lower interest expense.
Operating expenses at ALLETE Properties were up $2.9 million in 2004 because of
more land sales. Corporate charges increased $3.0 million ($9.0 million in 2004;
$6.0 million in 2003) reflecting higher compensation and benefit costs, and $1.7
million of costs associated with the planned spin-off of Automotive Services.
Interest expense not specifically related to any one business segment decreased
$5.5 million ($8.0 million in 2004; $13.5 million in 2003) due to the redemption
of quarterly income preferred securities and various long-term debt issues in
2003 with both the proceeds from the sale of our Water Services businesses and
internally generated cash.
CRITICAL ACCOUNTING POLICIES
Certain accounting measurements under applicable GAAP involve management's
judgment about subjective factors and estimates, the effects of which are
inherently uncertain. Accounting measurements that we believe are most critical
to our reported results of operations and financial condition include:
uncollectible receivables and allowance for doubtful accounts, impairment of
goodwill and long-lived assets, pension and postretirement health and life
actuarial assumptions, valuation of investments and provisions for environmental
remediation. These policies are reviewed with the Audit Committee of our Board
of Directors on a regular basis and summarized in our 2003 Form 10-K.
OUTLOOK
SPIN-OFF OF AUTOMOTIVE SERVICES. In June 2004 ADESA issued 6.3 million shares of
common stock through an IPO priced at $24.00 per share. This represented 6.6
percent of ADESA's 94.9 million shares outstanding. ALLETE will account for the
6.6 percent public ownership of ADESA as a minority interest and continue to own
and consolidate the remaining portion of ADESA until the completion of the
spin-off of ADESA from ALLETE. Also in June 2004, ADESA substantially completed
the restructuring of debt in conjunction with its June IPO and planned spin-off
from ALLETE. (See Note 7.) ALLETE's Board of Directors is expected to meet in
late August 2004 to finalize details of the spin-off of Automotive Services,
which is expected to be completed by the end of September 2004. The spin-off is
expected to take the form of a tax-free stock dividend to ALLETE's shareholders,
who would receive a pro rata number of shares of ADESA common stock for each
share of ALLETE common stock that they own. The spin-off is subject to the
approval of the final plan by ALLETE's Board of Directors, favorable market
conditions, receipt of tax opinions and other customary conditions.
ALLETE Second Quarter 2004 Form 10-Q 24
2004 EARNINGS GUIDANCE. After the spin-off of Automotive Services is completed,
ALLETE will be comprised of what is now classified as (1) Energy Services, and
(2) Investments and Corporate Charges. In 2003 net income from these operations
totaled $28.3 million. ALLETE estimates that 2004 net income from these
remaining businesses will increase 15 percent over 2003. The earnings guidance
does not include approximately $15 million after tax of Automotive Services
spin-off related expenses for advisor fees and debt retirement premiums that are
being incurred this year. This guidance does reflect the impact of cash received
from ADESA after the IPO which was invested and used for debt reduction.
ENERGY SERVICES. In February 2004 we experienced a generator failure at our
534-MW Boswell Energy Center Unit 4 (Unit 4). Unit 4 came back into service in
June. As a result of the failure, we replaced significant components of the
generator at a capital cost of approximately $6 million. The majority of the
replacement cost was covered by insurance, subject to a deductible of $1
million. We entered into power purchase agreements to replace the power lost
during the Unit 4 outage. The cost of this additional power is being recovered
through the regulated utility fuel adjustment clause in Minnesota. While Unit 4
was down, some work originally planned for 2005 and 2006 was done during the
outage to minimize future outages. This outage did not have a material impact on
our results of operations. Wisconsin Public Power, Inc. owns 20 percent of Unit
4.
Minnesota Power does not expect to file a request to increase rates for its
retail utility operations during 2005. We will, however, continue to monitor the
costs of serving our retail customers and evaluate the need for a rate filing in
the future.
SWL&P's application with the PSCW for authority to increase retail utility rates
6.1 percent for its Wisconsin electric utility operations was filed in June
2004. The request covers increases in the cost of doing business. New rates, if
approved, are expected to go into effect in early 2005.
We will file an integrated resource plan with the MPUC in the third quarter of
2004 detailing our retail energy demand projections and our energy sourcing
options to meet the projected demand. The projections will include the future
energy needs of our existing customers, including contemplated expansions. We
expect to see modest growth in our retail and regulated wholesale loads over the
next 15 years with potential for more robust growth depending on several key
expansion opportunities being pursued by customers in the steel, paper and
pipeline industries we serve.
INVESTMENTS AND CORPORATE CHARGES. ALLETE Properties, our Florida real estate
operations, owns approximately 17,000 acres of land near Fort Myers, Palm Coast
and Ormond Beach, Florida, as well as Winter Haven Citi Centre, a retail
shopping center in Winter Haven, Florida. We add value to the land through
entitlements and infrastructure improvements, and then sell it at current market
prices. Historically, proceeds from land sales have been three to four times our
carrying value. Rental income at the retail shopping center in Winter Haven
provides a recurring stream of revenue. At June 30, 2004 our basis in land held
by ALLETE Properties was $47.1 million. ALLETE Properties occasionally provides
seller financing, and outstanding finance receivables were $10.8 million at June
30, 2004 with maturities ranging up to ten years. Outstanding finance
receivables accrue interest at market-based rates. At June 30, 2004 ALLETE
Properties also had $18.2 million of other assets which consisted primarily of
Winter Haven Citi Centre. We may selectively acquire additional land if it meets
our strategy of adding value through entitlement and infrastructure
improvements.
SALE OF REMAINING WATER ASSETS. In June 2004 we essentially concluded our
strategy to exit our Water Services businesses when we completed the sales of
our North Carolina water assets and the sale of the remaining 72 water and
wastewater systems in Florida. The net cash proceeds from the sale of all water
assets in 2003 and 2004, after transaction costs, retirement of most Florida
Water debt and payment of income taxes, were approximately $300 million. These
net proceeds were used to strengthen our balance sheet and retire debt. We
continue to expect to sell our water assets in Georgia in the second half of
2004.
25 ALLETE Second Quarter 2004 Form 10-Q
LIQUIDITY AND CAPITAL RESOURCES
CASH FLOW ACTIVITIES
A primary goal of our strategic plan is to improve cash flow from operations.
Our strategy includes growing the businesses both internally by expanding
facilities, services and operations (see Capital Requirements), and externally
through acquisitions.
Consolidated cash and cash equivalents was $602.9 million at June 30, 2004, an
increase of $383.3 million since December 31, 2003. Of total consolidated cash
and cash equivalents at June 30, 2004, $275.0 million was at Automotive Services
with the balance of $327.9 million held by ALLETE and its other subsidiaries.
Our Automotive Services business had $155.8 million of restricted cash at June
30, 2004 primarily consisting of funds held in escrow for the redemption of
certain debt in August 2004. (See Note 7.)
In June 2004 ADESA completed an initial public offering of 6.3 million shares at
$24.00 per share which netted proceeds of $136.0 million after transaction
costs. ADESA also completed the restructuring of its debt in conjunction with
the IPO and planned spin-off from ALLETE, and in June 2004 issued $125 million
of senior notes and borrowed $275 million under a new $525 million credit
facility. With these funds, ADESA repaid $75.1 million of previously existing
debt and all intercompany debt outstanding to ALLETE. In July 2004 ADESA also
announced the August 2004 redemption of $125 million in outstanding long-term
debt. See Note 3 for additional detail on the IPO and Note 7 for additional
detail on debt issued, repaid and slated for redemption.
In the first half of 2004, ALLETE repaid $56.3 million in outstanding debt using
internally generated funds and proceeds from the sale of our Water Services
assets. In July 2004 ALLETE repaid $125 million in senior long-term notes with
proceeds received from ADESA and the sale of our Water Services assets. Also in
July 2004, ALLETE announced the August 2004 redemption of $111.0 million in
long-term debt that is expected to be refinanced in August 2004 at a more
favorable interest rate. See Notes 7 and 8 for additional detail on debt repaid
and slated for redemption.
During the first six months of 2004 and 2003, cash flow from operating
activities was affected by a number of factors representative of normal
operations.
WORKING CAPITAL. Additional working capital, if and when needed, generally is
provided by the sale of commercial paper. Approximately 3.4 million original
issue shares of our common stock are available for issuance through Invest
Direct, our direct stock purchase and dividend reinvestment plan.
A substantial amount of ADESA's working capital is generated internally from
payments for services provided. ADESA had historically funded short term swings
in working capital through lines of credit from ALLETE. In June 2004 ADESA
secured a revolving line of credit and expects this credit facility to
sufficiently meet its working capital needs and the needs of its subsidiaries
for the foreseeable future. During the sales process, ADESA does not generally
take title to or ownership of the vehicles consigned for auction but instead
facilitates the transfer of vehicle ownership directly from sellers to buyers.
AFC offers floorplan financing for dealers to purchase vehicles mostly at
auctions and takes a security interest in each financed vehicle. The financing
is provided through the earlier of the date the dealer sells the vehicle or a
general borrowing term of 30 to 45 days.
Significant changes in accounts receivable and accounts payable balances at June
30, 2004 compared to December 31, 2003 were due to increased sales and financing
activity at Automotive Services. Typically auction volumes are down during
December because of the holidays. As a result, ADESA and AFC had higher
receivables and higher payables at June 30, 2004.
AFC RECEIVABLES. AFC sells the majority of U.S. dollar denominated finance
receivables on a revolving basis to a wholly owned, bankruptcy remote, special
purpose subsidiary that is consolidated for accounting purposes. AFC and the
special purpose subsidiary amended it securitization agreement in June 2004
concurrent with the completion of ADESA's IPO. The agreement expires in January
2005 subject to annual renewal and allows for the revolving sale to a bank
conduit facility of up to a maximum of $500 million in undivided interests in
eligible finance receivables subject to committed liquidity. AFC's receivables
are discussed in Note 2.
ALLETE Second Quarter 2004 Form 10-Q 26
SECURITIES. In March 2001 ALLETE, ALLETE Capital II and ALLETE Capital III,
jointly filed a registration statement with the SEC pursuant to Rule 415 under
the Securities Act of 1933. The registration statement, which has been declared
effective by the SEC, relates to the possible issuance of a remaining aggregate
amount of $387 million of securities which may include ALLETE common stock,
first mortgage bonds and other debt securities, and ALLETE Capital II and ALLETE
Capital III preferred trust securities. ALLETE also previously filed a
registration statement, which has been declared effective by the SEC, relating
to the possible issuance of $25 million of first mortgage bonds and other debt
securities. We may sell all or a portion of the remaining registered securities
if warranted by market conditions and our capital requirements. Any offer and
sale of the above mentioned securities will be made only by means of a
prospectus meeting the requirements of the Securities Act of 1933 and the rules
and regulations thereunder.
CREDIT RATINGS
Our securities have been rated by Standard & Poor's Ratings Services, a division
of The McGraw-Hill Companies, Inc. (Standard & Poor's) and by Moody's Investors
Service, Inc. (Moody's).
In May 2004 Standard & Poor's affirmed ALLETE's BBB+ corporate credit rating and
removed the rating from CREDITWATCH with developing implications. Also in May
2004, Moody's affirmed ALLETE's senior secured debt at a Baa1 rating, Issuer
Rating and senior unsecured debt at Baa2, and Prime-2 short term rating for
commercial paper. Both agencies indicated that the spin-off of ADESA would not
impact these ratings.
Rating agencies use both quantitative and qualitative measures in determining a
company's credit rating. These measures include business risk, liquidity risk,
competitive position, capital mix, financial condition, predictability of cash
flows, management strength and future direction. Some of the quantitative
measures can be analyzed through a few key financial ratios, while the
qualitative ones are more subjective. The disclosure of these credit ratings is
not a recommendation to buy, sell or hold our securities. Ratings are subject to
revision or withdrawal at any time by the assigning rating organization. Each
rating should be evaluated independently of any other rating.
CAPITAL REQUIREMENTS
Consolidated capital expenditures for the six months ended June 30, 2004 totaled
$43.4 million ($67.5 million in 2003). Expenditures for the six months ended
June 30, 2004 included $34.5 million for Energy Services, $5.7 million for
Automotive Services and $0.2 million for Investments and Corporate Charges.
Expenditures for the six months ended June 30, 2004 also included $3.0 million
to maintain our remaining Water Services businesses while they were in the
process of being sold. Internally generated funds were the primary source of
funding for these expenditures.
ENVIRONMENTAL MATTERS AND OTHER
Our businesses are subject to regulation by various U.S. and Canadian, federal,
state, provincial and local authorities concerning environmental matters. We do
not currently anticipate that potential expenditures for environmental matters
will be material; however, we are unable to predict the outcome of the issues
discussed in Note 13.
NEW ACCOUNTING STANDARDS
New accounting standards are discussed in Note 2.
----------------------------
READERS ARE CAUTIONED THAT FORWARD-LOOKING STATEMENTS INCLUDING THOSE CONTAINED
ABOVE, SHOULD BE READ IN CONJUNCTION WITH OUR DISCLOSURES UNDER THE HEADING:
"SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995" LOCATED ON PAGE 3 OF THIS FORM 10-Q.
27 ALLETE Second Quarter 2004 Form 10-Q
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
SECURITIES INVESTMENTS
Investments include certain securities held for an indefinite period of time
which are accounted for as available-for-sale securities. Available-for-sale
securities are recorded at fair value with unrealized gains and losses included
in accumulated other comprehensive income, net of tax. Unrealized losses that
are other than temporary are recognized in earnings. At June 30, 2004 our
available-for-sale securities portfolio consisted of securities in a grantor
trust established to fund certain employee benefits. Our available-for-sale
securities portfolio had a fair value of $21.1 million at June 30, 2004 ($20.2
million at December 31, 2003) and a total unrealized after-tax gain of $1.1
million at June 30, 2004 ($0.8 million at December 31, 2003).
As part of our emerging technology portfolio, we have several minority
investments in venture capital funds and direct investments in privately-held
start-up companies. These investments are accounted for using the cost method
and included in Investments on our consolidated balance sheet. The total
carrying value of these investments was $26.9 million at June 30, 2004 ($37.5
million at December 31, 2003). Our policy is to quarterly review these
investments for impairment by assessing such factors as continued commercial
viability of products, cash flow and earnings. Any impairment would reduce the
carrying value of the investment. During the second quarter of 2004 we recorded
$7.9 million ($4.7 million after taxes) of impairment losses primarily related
to direct investments in certain privately-held start-up companies whose future
business prospects have diminished significantly. Recent developments at these
companies indicate that future commercial viability is unlikely, as is new
financing necessary to continue development.
The total carrying value at June 30, 2004 included $20.4 million for investments
in three venture capital funds that have a current fund reported value of
approximately $10 million. The venture capital funds invest in many
privately-held start-up companies, and generally value the investments at the
most recent round of equity financing with failed investments written down to
zero. Experience indicates that failures in the fund's portfolio emerge early
while successful companies tend to take longer to materialize. In addition, the
most recent round of equity financing may produce a low valuation as it would
not reflect subsequent positive developments occurring at the various companies
in which the funds have invested. Based on our evaluation of these three venture
capital funds, we anticipate that the funds' future value will exceed our
carrying value as successful companies emerge and become fully valued. We have
the ability and intent to hold our investment in these venture capital funds for
a reasonable period of time sufficient for the forecasted valuation to be
realized. As such, we did not consider these venture capital fund investments to
be other-than-temporarily impaired at June 30, 2004.
FOREIGN CURRENCY
Our foreign currency exposure is limited to the conversion of the operating
results of our Automotive Services' Canadian subsidiaries and, to a lesser
extent, Mexican subsidiaries. We have not entered into any foreign exchange
contracts to hedge the conversion of Automotive Services' Canadian or Mexican
operating results into United States dollars. Mexican operations are not
material.
INTEREST RATES
In June 2004 ADESA entered into two interest rate swap agreements with notional
amounts of $105 million and $60 million to manage its exposure to interest rate
movements on its variable rate debt. Both interest rate swap agreements contain
amortizing provisions and mature in December 2006. ADESA has designated its
interest rate swap agreements as cash flow hedges. The fair value of the
interest rate swap agreements is estimated using pricing models widely used in
financial markets and represents the estimated amount ADESA would receive or pay
to terminate the agreement at the reporting date. At June 30, 2004 the fair
value of the interest rate swap agreements is an unrealized loss of $0.6 million
and is recorded in accrued expenses and other liabilities on the consolidated
balance sheet. In accordance with the provisions of SFAS 133, "Accounting for
Derivative Instruments and Hedging Activities," changes in the fair value of the
interest rate swap agreements designated as cash flow hedges are recorded in
Accumulated Other Comprehensive Income. ADESA is exposed to credit loss in the
event of nonperformance by the counterparties; however, nonperformance is not
anticipated.
ALLETE Second Quarter 2004 Form 10-Q 28
COMMODITY PRICE RISK
Our regulated utility operations in Minnesota and Wisconsin incur costs for fuel
(primarily coal), power and natural gas purchased for resale in our regulated
service territories, and related transportation. Our regulated utilities'
exposure to price risk for these commodities is significantly mitigated by the
current ratemaking process and regulatory environment which generally allows a
fuel clause surcharge if costs are in excess of those in our last rate filing.
Conversely, costs below those in our last rate filing result in a rate credit.
We prudently manage our customers' exposure to price risk by entering into
contracts of various durations and terms for the purchase of coal and power (in
Minnesota), power and natural gas (in Wisconsin), and related transportation
costs.
POWER MARKETING
Our power marketing activities consist of (i) purchasing energy in the wholesale
market for resale in our regulated service territories when retail energy
requirements exceed generation output, and (ii) selling excess available
regulated utility generation and purchased power, as well as selling
nonregulated generation.
From time-to-time, our regulated utility operations may have excess generation
that is temporarily not required by retail and municipal customers in our
regulated service territory. We actively sell this generation to the wholesale
market to optimize the value of our generating facilities. This generation is
generally sold in the spot market or under short-term contracts at market
prices.
We have approximately 500 MW of nonregulated generation available for sale to
the wholesale markets. This primarily consists of about 200 MW at our Taconite
Harbor facility in northern Minnesota and 275 MW obtained through a 15-year
power purchase agreement with a wholly owned subsidiary of NRG Energy at the
Kendall County facility near Chicago, Illinois.
The majority of Taconite Harbor's capability of approximately 200 MW has been
sold through various short-term and long-term capacity and energy contracts.
Short term, we have approximately 180 MW of capacity and energy sales contracts
and a 15 MW forward energy sales contract, all of which expire on April 30,
2005. Long term, we have entered into two capacity and energy sales contracts
totaling 175 MW (201 MW including a 15 percent reserve) which are effective May
1, 2005 and expire on April 30, 2010. Both contracts contain fixed monthly
capacity charges and fixed minimum energy charges. One contract provides for an
annual escalator to the energy charge based on increases in our cost of coal,
subject to a small minimum annual escalation. The other contract provides that
the energy charge will be the greater of a fixed minimum charge or an amount
based on the variable production cost of a combined cycle natural gas unit. Our
exposure in the event of a full or partial outage at our Taconite Harbor
facility is significantly limited under both contracts. When the buyer is
notified at least two months prior to an outage, there is no exposure. Outages
with less than two months notice are subject to an annual duration limitation
typical of this type of contract.
Under the Kendall County agreement, which expires in September 2017, we pay a
fixed capacity charge for the right, but not the obligation, to capacity and
energy from a 275 MW generating unit. We are responsible for arranging the
natural gas fuel supply. Our strategy is to sell a significant portion of this
generation through long-term contracts of various durations. The balance will be
sold in the daily spot market or through short-term contracts. We currently have
long-term capacity sales contracts for 130 MW, with 50 MW expiring in April 2012
and the balance expiring in September 2017. To date, the Kendall County facility
has operated at a loss due to negative spark spreads (the differential between
electric and natural gas prices) in the wholesale power market and our resulting
inability to cover the fixed capacity charge on the unsold capacity (currently
145 MW). We expect the facility to continue to generate losses until such time
as spark spreads improve or we are able to enter into additional long-term
capacity sales contracts. We are currently exploring options to minimize or
eliminate these ongoing losses.
29 ALLETE Second Quarter 2004 Form 10-Q
ITEM 4. CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable
assurance as to the reliability of the financial statements and other
disclosures included in this report, as well as to safeguard assets from
unauthorized use or disposition. We evaluated the effectiveness of the design
and operation of our disclosure controls and procedures under the supervision
and with the participation of management, including our chief executive officer
and chief financial officer, as of the end of the period covered by this Form
10-Q. Based upon that evaluation, our chief executive officer and chief
financial officer concluded that our disclosure controls and procedures are
effective in timely alerting them to material information required to be
included in our periodic SEC filings. There has been no change in our internal
control over financial reporting that occurred during our most recent fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Material legal and regulatory proceedings are included in the discussion of
Other Information in Item 5. and are incorporated by reference herein.
In late 2003 the staff of the SEC initiated an informal inquiry relating to our
internal audit function, internal financial reporting and the loan loss
methodology at AFC. We have fully and voluntarily cooperated with the informal
inquiry, and the SEC staff has not asserted that we have acted improperly or
illegally. Although we cannot predict the length, scope or results of the
informal inquiry, based upon extensive review by the Audit Committee of our
Board of Directors with the assistance of independent counsel and our
independent auditors, we believe that we have acted appropriately and that this
inquiry will not result in action that has a material adverse impact on us or
our reported results of operations. The results of the review by our Audit
Committee and independent counsel were submitted to the SEC in late February
2004. We have had no further communication with the SEC on this matter.
See Note 4 for a discussion on the ADESA Importation litigation.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND
ISSUER PURCHASES OF EQUITY SECURITIES
TOTAL NUMBER MAXIMUM
OF SHARES NUMBER OF
PURCHASED AS SHARES THAT
PART OF MAY YET BE
TOTAL PUBLICLY PURCHASED
NUMBER OF AVERAGE ANNOUNCED UNDER THE
ALLETE COMMON STOCK REPURCHASES SHARES PRICE PAID PLANS OR PLANS OR
AS OF JUNE 30, 2004 PURCHASED PER SHARE PROGRAMS PROGRAMS
- --------------------------------------------------------------------------------------------------------------------
For the Quarter Ended March 31, 2004
January - - - -
February 6,333 $31.75 - -
March 15,247 $34.14 - -
- --------------------------------------------------------------------------------------------------------------------
21,580 $33.44 - -
- --------------------------------------------------------------------------------------------------------------------
For the Quarter Ended June 30, 2004
April 4,751 $34.99 - -
May - - - -
June 5,220 $35.81 - -
- --------------------------------------------------------------------------------------------------------------------
9,971 $35.42 - -
- --------------------------------------------------------------------------------------------------------------------
Six Months Ended June 30, 2004 31,551 $34.06 - -
- --------------------------------------------------------------------------------------------------------------------
Repurchased pursuant to the stock-for-stock exercise of employee options granted under the ALLETE Executive
Long-Term Incentive Compensation Plan.
ALLETE Second Quarter 2004 Form 10-Q 30
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) We held our Annual Meeting of Shareholders on May 11, 2004.
(b) Included in (c) below.
(c) The election of directors and the ratification of the appointment of
independent auditors were voted on at the Annual Meeting of Shareholders.
The results were as follows:
VOTES
WITHHELD BROKER
VOTES FOR OR AGAINST ABSTENTIONS NONVOTES
---------------------------------------------------------------------------------------------------------------
DIRECTORS
Wynn V. Bussmann 73,129,135 1,603,112 - -
David G. Gartzke 73,389,211 1,343,036 - -
Dennis O. Green 73,061,647 1,670,600 - -
Peter J. Johnson 73,200,980 1,531,267 - -
George L. Mayer 73,189,932 1,542,315 - -
Roger D. Peirce 73,598,134 1,134,113 - -
Jack I. Rajala 73,462,836 1,269,411 - -
Nick Smith 73,745,576 986,671 - -
Bruce W. Stender 73,225,683 1,506,564 - -
Donald C. Wegmiller 73,385,366 1,346,881 - -
Deborah L. Weinstein 73,665,887 1,066,360 - -
INDEPENDENT AUDITORS
PricewaterhouseCoopers LLP 72,408,856 1,893,568 429,823 -
---------------------------------------------------------------------------------------------------------------
(d) Not applicable.
ITEM 5. OTHER INFORMATION
Reference is made to our 2003 Form 10-K for background information on the
following updates. Unless otherwise indicated, cited references are to our 2003
Form 10-K.
Ref. Page 12 - First Full Paragraph
In October 2003 the FPSC voted to initiate an investigation into the ratemaking
considerations of the gain on sale of Florida Water's assets, and whether gains
should be shared with the previous customers of Florida Water. In June 2004
Florida enacted legislation which provides that gains or losses resulting from
the purchase or condemnation of a utility's assets, which results in the loss of
customers and revenue served by such assets, are to be borne by the shareholders
of the utility. This applies to all transactions prior to and after the
effective date of the new law.
Ref. Page 17 - Fifth Paragraph
Minnesota Power does not expect to file a request to increase rates for its
retail utility operations during 2005. We will, however, continue to monitor the
costs of serving our retail customers and evaluate the need for a rate filing in
the future.
Ref. Page 17 - Following the Sixth Paragraph
On May 21, 2004 the MPUC approved Minnesota Power's 2004 capital structure
petition. Minnesota Power requested a common equity ratio of 58.44 percent with
a contingency window of plus or minus 15 percent (49.67 percent to 67.21
percent). The Company's total consolidated capitalization was requested at $3.0
billion with a contingency cap of $300 million. The Company requested approval
of a total consolidated capitalization of $1.5 billion with a contingency cap of
$150 million once the spin-off of Automotive Services is completed.
31 ALLETE Second Quarter 2004 Form 10-Q
Ref. Page 17 - Ninth Paragraph
On June 3, 2004 SWL&P filed an application with the PSCW for authority to
increase retail utility rates 6.1 percent. This average increase is comprised of
a 4.0 percent increase in electric rates, a 7.0 percent increase in gas rates
and a 12.1 percent increase in water rates. The proposed increases are due to
increased operating costs, primarily pension, insurance, gross receipts tax and
parent company service costs. SWL&P is requesting a 12.25 percent return on
common equity. Hearings are anticipated to be held in late 2004 with new rates
expected to go into effect in early 2005.
Ref. Page 18 - First Paragraph
Ref. Form 10-Q for the quarter ended March 31, 2004, Page 26 - Fourth Paragraph
On June 7, 2004 Save Our Unique Lands (SOUL) and the North American Water Office
(NAWO) filed a complaint against Minnesota Power at the MPUC. The complaint
alleges that Minnesota Power does not intend to own the Duluth to Wausau
transmission line, that the American Transmission Company (ATC) is not a
jurisdictional utility under Minnesota law and lacks the power of eminent domain
and the ability to conduct business, and that the technical aspects of the line
have changed significantly since the Minnesota Environmental Quality Board
(MEQB) approved Minnesota Power's request to be exempt from the requirements of
the Minnesota Power Plant Siting Act for the construction of the 12 miles of
line in Minnesota. For those reasons, SOUL and NAWO requested that the MPUC
overturn the MEQB decision, assert jurisdiction over the project, require ATC to
obtain a Certificate of Need to build the line, and direct the Office of
Attorney General to initiate proceedings against Minnesota Power and ATC for
unauthorized transmission construction in Minnesota. On July 15, 2004 Minnesota
Power filed a reply to the MPUC's request for comments on the complaint.
Minnesota Power stated that the MEQB exemption was still effective and that the
complaint had no merit. The Minnesota Department of Commerce supported Minnesota
Power's position in their comments.
Ref. Page 26 - Second through Fifth Paragraphs
Ref. Form 10-Q for the quarter ended March 31, 2004, Page 26 - Sixth Paragraph
In August 2004 ADESA expects to present a detailed engineering proposal to the
Taunton City Council.
ADESA has an accrual of $1.2 million at June 30, 2004 with respect to this
matter, including the estimated costs (as of June 30, 2004) associated with the
proposal to extend the municipal water service.
In addition, ADESA has received correspondence from an attorney representing
residents of the adjoining residential community suggesting that ADESA enter
into discussions concerning property damage claims for diminution in value due
to the MTBE release. Accordingly, there is a possibility that property damage
litigation may be filed against ADESA. Potential losses in these matters are not
considered probable by ADESA management or cannot be reasonably estimated.
Accordingly, ADESA has not recorded an accrual for the respective costs of these
matters.
Ref. Page 28 - Executive Officers of the Registrant
Ref. Page 54 - Fourth Paragraph
Effective July 20, 2004 Donald W. Stellmaker was appointed treasurer of ALLETE
by our Board of Directors. Stellmaker, 47, joined ALLETE in 1980. His previous
positions included manager and director of corporate financial planning and
budgeting at ALLETE.
ALLETE Second Quarter 2004 Form 10-Q 32
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
3 Bylaws of ALLETE, Inc., as amended effective July 20, 2004.
*4 Indenture, dated June 21, 2004, between ADESA, Inc. and LaSalle
Bank National Association, as trustee (filed as Exhibit 4.2
to ADESA, Inc.'s June 30, 2004 Form 10-Q, File No. 1-32198).
+10(a) July 2004 amendment to the ALLETE Executive Annual Incentive
Plan.
+10(b) July 2004 amendment to the Minnesota Power and Affiliated
Companies Executive Investment Plan I.
+10(c) July 2004 amendment to the Minnesota Power and Affiliated
Companies Executive Investment Plan II.
+10(d) July 2004 amendment to the ALLETE Executive Long-Term Incentive
Compensation Plan.
+10(e) July 2004 amendment to the ALLETE Director Stock Plan.
*+10(f) ADESA, Inc. 2004 Equity and Incentive Plan (filed as Exhibit
10.14 to ADESA's June 11, 2004 S-1/A, File No. 333-113499).
*+10(g) ADESA, Inc. Director Compensation Plan (filed as Exhibit 10.15
to ADESA's June 11, 2004 S-1/A, File No. 333-113499).
*+10(h) ADESA, Inc. Director Compensation Deferral Plan (filed as
Exhibit 10.16 to ADESA's June 11, 2004 S-1/A, File No.
333-113499).
*+10(i) ADESA, Inc. Employee Stock Purchase Plan (filed as Exhibit 10.17
to ADESA's June 11, 2004 S-1/A, File No. 333-113499).
*+10(j) ADESA, Inc. (formerly ADESA Corporation) Supplemental Executive
Retirement Plan and First through Fifth Amendments (filed as
Exhibits 10.18 through 10.23 to ADESA's June 30, 2004 Form 10-Q,
File No. 1-32198).
*10(k) Credit Agreement, dated June 21, 2004, among ADESA, Inc., as
Borrower, the Guarantors party thereto, as Subsidiary
Guarantors, the Lenders party thereto and UBS Securities LLC and
Merrill Lynch & Co., as Joint Lead Arrangers and
Co-Bookmanagers, Bank One, N.A., General Electric Capital
Corporation, Keybank National Association, SunTrust Bank and
U.S. Bank National Association as Co-Documentation Agents,
Merrill Lynch & Co., as Syndication Agent, UBS AG, Stamford
Branch, as Issuing Bank, Administrative Agent and Collateral
Agent, and UBS Loan Finance LLC, as Swingline Lender (filed as
Exhibit 10.5 to ADESA, Inc.'s June 30, 2004 Form 10-Q, File No.
1-32198).
*10(l) Second Amended and Restated Receivable Purchase Agreement, dated
June 15, 2004, among AFC Funding Corporation, as Seller,
Automotive Finance Corporation, as Servicer, Fairway Finance
Company, LLC and such other entities from time to time as may
become Purchasers thereunder, Harris Nesbitt Corp., as the
Initial Agent and as Purchaser Agent for Fairway Finance
Company, LLC and XL Capital Assurance Inc., as Insurer (filed as
Exhibit 10.6 to ADESA, Inc.'s June 30, 2004 Form 10-Q, File No.
1-32198).
*10(m) Amendment No. 1 to Amended and Restated Purchase and Sale
Agreement, dated June 15, 2004, between AFC Funding Corporation
and Automotive Finance Corporation (filed as Exhibit 10.7 to
ADESA, Inc.'s June 30, 2004 Form 10-Q, File No. 1-32198).
*10(n) Master Separation Agreement, dated June 4, 2004, between ALLETE,
Inc. and ADESA, Inc. (filed as Exhibit 10.1 to ADESA, Inc.'s
June 30, 2004 Form 10-Q, File No. 1-32198).
33 ALLETE Second Quarter 2004 Form 10-Q
31(a) Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive
Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
31(b) Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial
Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
32 Section 1350 Certification of Periodic Report by the Chief
Executive Officer and Chief Financial Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
We are a party to other long-term debt instruments that, pursuant to Regulation
S-K, Item 601(b)(4)(iii), are not filed as exhibits since the total amount of
debt authorized under each such omitted instrument does not exceed 10 percent of
our total consolidated assets. These instruments include the following:
- $38,995,000 City of Cohasset, Minnesota, Variable Rate Demand
Revenue Refunding Bonds (Minnesota Power & Light Company
Project) Series 1997A, Series 1997B, Series 1997C and Series
1997D.
- $35,105,000 Collier County Industrial Development Authority,
6.50% Industrial Development Refunding Revenue Bonds (Florida
Water Services Corporation, formerly Southern States Utilities,
Inc., Project) Series 1996.
We will furnish copies of these instruments to the SEC upon its request.
- -------------------------
* Incorporated herein by reference as indicated.
+ Management contract or compensatory plan or arrangement.
(b) Reports on Form 8-K.
Report on Form 8-K filed June 1, 2004 with respect to Item 5. Other Events
and Regulation FD Disclosure.
Report on Form 8-K filed June 16, 2004 with respect to Item 5. Other Events
and Regulation FD Disclosure.
Report on Form 8-K filed June 22, 2004 with respect to Item 5. Other Events
and Regulation FD Disclosure.
Report on Form 8-K filed July 1, 2004 with respect to Item 5. Other Events
and Regulation FD Disclosure.
ALLETE Second Quarter 2004 Form 10-Q 34
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ALLETE, INC.
August 6, 2004 James K. Vizanko
----------------------------------------------------
James K. Vizanko
Senior Vice President and Chief Financial Officer
August 6, 2004 Mark A. Schober
----------------------------------------------------
Mark A. Schober
Senior Vice President and Controller
35 ALLETE Second Quarter 2004 Form 10-Q
EXHIBIT INDEX
EXHIBIT
NUMBER
- --------------------------------------------------------------------------------
3 Bylaws of ALLETE, Inc., as amended effective July 20, 2004.
10(a) July 2004 amendment to the ALLETE Executive Annual Incentive Plan.
10(b) July 2004 amendment to the Minnesota Power and Affiliated Companies
Executive Investment Plan I.
10(c) July 2004 amendment to the Minnesota Power and Affiliated Companies
Executive Investment Plan II.
10(d) July 2004 amendment to the ALLETE Executive Long-Term Incentive
Compensation Plan.
10(e) July 2004 amendment to the ALLETE Director Stock Plan.
31(a) Rule 13a-14(a)/15d-14(a) Certification by the Chief Executive Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31(b) Rule 13a-14(a)/15d-14(a) Certification by the Chief Financial Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32 Section 1350 Certification of Periodic Report by the Chief Executive
Officer and Chief Financial Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
ALLETE Second Quarter 2004 Form 10-Q