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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[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 Number 1-7296
NORTHERN ILLINOIS GAS COMPANY
(Doing business as Nicor Gas Company)
(Exact name of registrant as specified in its charter)
Illinois 36-2863847
(State of Incorporation) (I.R.S. Employer
Identification Number)
1844 Ferry Road
Naperville, Illinois 60563-9600 (630)305-9500
(Address of principal executive offices) (Registrant's telephone number)
The registrant meets the conditions set forth in General Instruction
H(1)(a) and (b) of Form 10-Q and is therefore filing this Form with a reduced
disclosure format.
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 [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date. Common stock, par value $5,
outstanding at August 6, 2004, were 15,232,414 shares, all of which are owned by
Nicor Inc.
Nicor Gas Company Page i
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Table of Contents
Part I - Financial Information
Item 1. Financial Statements - (Unaudited) ................................ 1
Consolidated Statements of Operations:
Three and six months ended
June 30, 2004 and 2003 .......................................... 2
Consolidated Statements of Cash Flows:
Six months ended
June 30, 2004 and 2003 .......................................... 3
Consolidated Balance Sheets:
June 30, 2004 and 2003, and
December 31, 2003 ............................................... 4
Notes to the Consolidated Financial Statements .................... 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ...............................15
Item 4. Controls and Procedures ...........................................24
Part II - Other Information
Item 1. Legal Proceedings .................................................25
Item 6. Exhibits and Reports on Form 8-K ..................................25
Signature .........................................................26
Exhibit Index .....................................................27
Glossary
Degree day........The extent to which the daily average temperature falls below
65 degrees Fahrenheit. Normal weather for Nicor Gas' service
territory, for purposes of this report, is considered to be
about 6,000 degree days per year.
ICC...............Illinois Commerce Commission, the agency that regulates
investor-owned Illinois utilities.
FERC..............Federal Energy Regulatory Commission, the agency that
regulates the interstate transportation of natural gas, oil
and electricity.
Mcf, MMcf, Bcf....Thousand cubic feet, million cubic feet, billion cubic feet.
PBR...............Performance-based rate, a regulatory plan that provided
economic incentives based on natural gas cost performance.
Nicor Gas Company Page 1
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PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
The following condensed unaudited consolidated financial statements of Nicor Gas
have been prepared by the company pursuant to the rules and regulations of the
Securities and Exchange Commission (SEC). Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States have been
condensed or omitted pursuant to SEC rules and regulations. The condensed
financial statements should be read in conjunction with the financial statements
and the notes thereto included in the company's 2003 Annual Report on Form
10-K/A (Amendment No. 1).
The information furnished reflects, in the opinion of the company, all
adjustments (consisting only of normal recurring adjustments) necessary for a
fair statement of the results for the interim periods presented. Results for the
interim periods presented are not necessarily indicative of the results to be
expected for the full fiscal year due to seasonal and other factors.
Nicor Gas Company Page 2
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Consolidated Statements of Operations (Unaudited)
(millions)
Three months ended Six months ended
June 30 June 30
------------------ ------------------
2004 2003 2004 2003
-------- -------- -------- --------
Operating revenues (includes revenue
taxes of $25.2, $24.6, $96.1 and
$86.9, respectively) $ 338.4 $ 379.5 $1,373.5 $1,476.2
------- -------- -------- --------
Operating expenses
Cost of gas 200.5 241.0 992.7 1,103.9
Operating and maintenance 54.5 54.7 117.8 113.1
Depreciation 37.4 36.0 74.6 72.1
Taxes, other than income taxes 29.1 27.9 103.8 94.0
Mercury-related costs (recoveries), net .2 (17.4) .1 (17.8)
Income taxes 2.9 10.9 23.5 34.2
------- -------- -------- --------
324.6 353.1 1,312.5 1,399.5
------- -------- -------- --------
Operating income 13.8 26.4 61.0 76.7
------- -------- -------- --------
Other income (expense), net
Property sale gains 5.5 .4 5.5 .4
Interest income .4 .4 .7 .9
Other, net - .1 (.4) (.2)
Income taxes on other income (2.1) (.3) (2.0) (.3)
------- -------- ------- --------
3.8 .6 3.8 .8
------- -------- ------- --------
Interest expense
Interest on debt, net of amounts
capitalized 8.4 8.1 18.3 16.6
Other (1.8) .4 (1.0) .9
------- -------- ------- --------
6.6 8.5 17.3 17.5
------- -------- ------- --------
Net income 11.0 18.5 47.5 60.0
Dividends on preferred stock - .1 - .2
------- -------- ------- --------
Earnings applicable to common stock $ 11.0 $ 18.4 $ 47.5 $ 59.8
======= ======== ======= ========
The accompanying notes are an integral part of these statements.
Nicor Gas Company Page 3
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Consolidated Statements of Cash Flows (Unaudited)
(millions)
Six months ended
June 30
-----------------
2004 2003
-------- -------
Operating activities
Net income $ 47.5 $ 60.0
Adjustments to reconcile net income to net cash flow
provided from operating activities:
Depreciation 74.6 72.1
Deferred income tax expense 7.5 9.6
Gain on sale of property, plant and equipment (5.5) (.4)
Other noncash items .8 .1
Changes in:
Receivables, less allowances 198.5 107.8
Gas in storage 193.7 .9
Deferred/accrued gas costs (4.9) (73.6)
Prepaid pension costs (2.2) -
Other assets (20.3) 25.0
Accounts payable 47.3 (96.5)
Temporary last-in, first-out liquidation 77.8 18.0
Other liabilities (9.2) (42.4)
-------- -------
Net cash flow provided from operating activities 605.6 80.6
-------- -------
Investing activities
Capital expenditures (75.2) (81.2)
Net proceeds from the sale of property, plant,
and equipment 7.2 .4
-------- -------
Net cash flow used for investing activities (68.0) (80.8)
-------- -------
Financing activities
Disbursements to retire long-term obligations (.5) (100.0)
Short-term borrowings (repayments), net (575.0) 20.0
Dividends paid (28.0) (36.2)
Other financing activities - (.5)
-------- -------
Net cash flow used for financing activities (603.5) (116.7)
-------- -------
Net decrease in cash and cash equivalents (65.9) (116.9)
Cash and cash equivalents, beginning of period 141.0 182.2
-------- -------
Cash and cash equivalents, end of period $ 75.1 $ 65.3
======== =======
The accompanying notes are an integral part of these statements.
Nicor Gas Company Page 4
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Consolidated Balance Sheets (Unaudited)
(millions)
June 30 December 31 June 30
2004 2003 2003
---------- ----------- ----------
Assets
------
Gas distribution plant, at cost $ 3,753.8 $ 3,694.8 $ 3,622.6
Less accumulated depreciation 1,384.2 1,349.6 1,319.7
---------- ----------- ----------
2,369.6 2,345.2 2,302.9
---------- ----------- ----------
Current assets
Cash and cash equivalents - affiliates - 97.5 65.3
Cash and cash equivalents - other 75.1 43.5 -
Receivables, less allowances of $26.1,
$19.4 and $22.5, respectively 201.8 384.9 277.3
Receivables - affiliates 9.0 24.4 8.0
Gas in storage, at last-in, first-out
(LIFO) cost 13.0 209.1 17.7
Deferred gas costs - - 6.3
Deferred income taxes 44.8 41.9 30.4
Other 49.1 27.5 10.7
---------- ----------- ----------
392.8 828.8 415.7
---------- ----------- ----------
Prepaid pension costs 179.3 177.1 177.1
Other assets 63.8 66.6 60.0
---------- ----------- ----------
$ 3,005.5 $ 3,417.7 $ 2,955.7
========== =========== ==========
Capitalization and Liabilities
------------------------------
Capitalization
Long-term obligations
Long-term bonds $ 495.0 $ 495.1 $ 396.4
Mandatorily redeemable preferred stock 4.6 5.1 -
---------- ----------- ----------
499.6 500.2 396.4
---------- ----------- ----------
Preferred stock
Mandatorily redeemable preferred stock - - 5.1
Non-redeemable preferred stock 1.4 1.4 1.4
---------- ----------- ----------
1.4 1.4 6.5
---------- ----------- ----------
Common equity
Common stock 76.2 76.2 76.2
Paid-in capital 108.1 108.1 108.1
Retained earnings 476.8 442.3 469.3
Accumulated other comprehensive
income (loss), net (1.5) (1.5) (1.1)
---------- ----------- ----------
659.6 625.1 652.5
---------- ----------- ----------
1,160.6 1,126.7 1,055.4
---------- ----------- ----------
Current liabilities
Long-term obligations due within one year .5 .5 .5
Short-term borrowings - 575.0 335.0
Accounts payable 355.1 307.8 365.2
Temporary LIFO liquidation 77.8 - 18.0
Accrued gas costs 42.1 47.0 -
Dividends payable - 15.0 -
Other 21.7 31.5 21.1
---------- ----------- ----------
497.2 976.8 739.8
---------- ----------- ----------
Deferred credits and other liabilities
Accrued future removal costs 694.0 670.0 645.0
Deferred income taxes 425.9 414.5 264.0
Regulatory income tax liability 46.5 48.4 60.3
Unamortized investment tax credits 34.2 35.6 36.5
Other 147.1 145.7 154.7
---------- ----------- ----------
1,347.7 1,314.2 1,160.5
---------- ----------- ----------
$ 3,005.5 $ 3,417.7 $ 2,955.7
========== =========== ==========
The accompanying notes are an integral part of these statements.
Nicor Gas Company Page 5
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Notes to the Consolidated Financial Statements (Unaudited)
The following notes should be read in conjunction with the financial statement
notes included in the Nicor Gas 2003 Annual Report on Form 10-K/A (Amendment No.
1). Nicor Gas is a wholly owned subsidiary of Nicor Inc. (Nicor). Results for
the interim periods presented are not necessarily indicative of the results to
be expected for the full fiscal year due to seasonal and other factors.
1. ACCOUNTING POLICIES
Gas in storage. Gas in storage inventory is carried at cost applying a last-in,
first-out (LIFO) method on a calendar-year basis. For interim periods, the
difference between estimated replacement cost and the LIFO cost for quantities
of gas temporarily withdrawn from storage is recorded in cost of gas and in
current liabilities as a temporary LIFO liquidation.
Regulatory assets and liabilities. Nicor Gas is regulated by the Illinois
Commerce Commission (ICC), which establishes the rules and regulations governing
utility rates and services in Illinois. The company applies accounting standards
that recognize the economic effects of rate regulation and, accordingly, has
recorded regulatory assets and liabilities. The company had regulatory assets
(liabilities) as follows (in millions):
June 30 December 31 June 30
2004 2003 2003
---------- ------------ ----------
Accrued future removal costs $ (694.0) $ (670.0) $ (645.0)
Deferred (accrued) gas cost (42.1) (47.0) 6.3
Regulatory income tax liability (46.5) (48.4) (60.3)
Deferred environmental costs 31.5 37.0 33.5
Unamortized losses on reacquired debt 20.4 20.9 18.5
Other noncurrent regulatory assets 1.2 - -
Other noncurrent regulatory liabilities (2.2) - -
---------- ----------- ----------
$ (731.7) $ (707.5) $ (647.0)
========== =========== ==========
Deferred environmental costs and unamortized losses on reacquired debt are
classified in other noncurrent assets. At December 31, 2003, accrued future
removal costs for all periods presented were reclassified from accumulated
depreciation to a noncurrent liability to conform to new guidance issued to the
utility industry. Accrued future removal costs at June 30, 2003 have similarly
been reclassified to conform to that presentation.
Revenue taxes. Nicor Gas classifies revenue taxes billed to customers as
operating revenues and related taxes incurred as operating expenses. Revenue
taxes included in operating expense for the three and six months ended June 30,
2004 were $24.5 million and $94 million, respectively, and $23.9 million and
$85.4 million, respectively, for the same periods ending June 30, 2003.
Income taxes. The company's effective income tax rate declined to 31 percent and
35 percent for the three and six months ended June 30, 2004, respectively, from
38 percent and 37 percent for the corresponding 2003 periods. The decline in
2004 was due principally to reduced projected income, which causes a lower
effective income tax rate since permanent differences and tax credits are a
larger share of pretax income, and a favorable IRS settlement in the second
quarter of 2004.
Nicor Gas Company Page 6
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Notes to the Consolidated Financial Statements (Unaudited) (continued)
2. NEW ACCOUNTING PRONOUNCEMENTS
Accounting for Medicare Prescription Drug, Improvement and Modernization Act. In
May 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff
Position No. FAS 106-2, Accounting and Disclosure Requirements Related to the
Medicare Prescription Drug, Improvement and Modernization Act of 2003 (FSP FAS
106-2). The Medicare Prescription Drug, Improvement and Modernization Act of
2003 (the Act) provides a prescription drug benefit as well as a potential
federal subsidy to sponsors of certain retiree health care benefit plans. FSP
FAS 106-2 provides guidance on accounting for the effects of the Act, including
the potential subsidy, and requires public companies to reflect the impact by
the third quarter of 2004 if determinable and significant. This requires an
employer to determine whether the prescription drug benefits provided are
actuarially equivalent to Medicare Part D, thereby making it eligible for a
subsidy under the Act.
These financial statements and accompanying notes do not reflect the effects of
FSP FAS 106-2. Without clarifying regulations, the company is unable to
determine the extent to which its prescription drug benefits are actuarially
equivalent. Any subsidy it might receive is not expected to have a significant
impact on periodic post retirement health care costs or net income.
Consolidation of Variable Interest Entities. In December 2003, the FASB issued
Interpretation 46(R), Consolidation of Variable Interest Entities (FIN 46R). FIN
46R addresses the application of Accounting Research Bulletin 51, Consolidated
Financial Statements, to certain entities in which equity investors do not have
the characteristics of a controlling financial interest or do not have
sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support. FIN 46R was effective for Nicor Gas
on January 1, 2004, and had no impact on the company's financial position or
results of operations.
3. ACCRUED UNBILLED REVENUES
Receivables include accrued unbilled revenues of $46.4 million, $139 million and
$57.4 million at June 30, 2004, December 31, 2003, and June 30, 2003,
respectively. Nicor Gas accrues revenues for estimated deliveries to customers
from the date of their last bill until the balance sheet date.
4. OTHER INCOME (EXPENSE), NET
Other income (expense), net consisted of the following (in millions):
Three months ended Six months ended
June 30 June 30
------------------ ------------------
2004 2003 2004 2003
--------- ------- --------- -------
Gains on sale of property,
plant and equipment $ 5.5 $ .4 $ 5.5 $ .4
Interest income .4 .4 .7 .9
Other income .2 .3 .5 .4
Other expense (.2) (.2) (.9) (.6)
Related income tax benefit (expense) (2.1) (.3) (2.0) (.3)
--------- ------- --------- --------
$ 3.8 $ .6 $ 3.8 $ .8
========= ======= ========= ========
Nicor Gas Company Page 7
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Notes to the Consolidated Financial Statements (Unaudited) (continued)
5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The recorded amount of short-term investments and short-term borrowings
approximates fair value because of the short maturity of the instruments.
Long-term debt outstanding, including current maturities, is recorded at the
principal balance outstanding. The principal balance of Nicor Gas' First
Mortgage Bonds outstanding was $500 million at June 30, 2004 and December 31,
2003, and $400 million at June 30, 2003. Based on quoted market interest rates,
the fair value of the company's First Mortgage Bonds outstanding, including
current maturities, was approximately $517 million, $530 million and $446
million at June 30, 2004, December 31, 2003 and June 30, 2003, respectively.
6. COMPREHENSIVE INCOME
Total comprehensive income, as defined by FAS No. 130, Reporting Comprehensive
Income, is equal to net income plus other comprehensive income and was as
follows (in millions):
Three months ended Six months ended
June 30 June 30
------------------ ------------------
2004 2003 2004 2003
-------- -------- -------- --------
Net income $ 11.0 $ 18.5 $ 47.5 $ 60.0
Other comprehensive income
(loss), net of tax - - - (.2)
-------- -------- -------- --------
Total comprehensive income $ 11.0 $ 18.5 $ 47.5 $ 59.8
======== ======== ======== ========
Net other comprehensive income (loss) consists primarily of unrealized gains and
losses from derivative financial instruments accounted for as cash flow hedges.
7. POSTRETIREMENT BENEFITS
Nicor Gas maintains a noncontributory defined benefit pension plan covering
substantially all employees hired prior to 1998. Pension benefits are based on
years of service and highest average salary for management employees and job
level for unionized employees. The benefit obligation related to collectively
bargained benefits considers the company's past practice of regular benefit
increases to reflect current wages. Nicor Gas also provides health care and life
insurance benefits to eligible retired employees under a plan that includes a
limit on the company's share of cost for most future retirees. The company's
postretirement benefit costs have been considered in rate proceedings on the
accrual basis.
About one-fourth of the net periodic benefit cost or credit related to these
plans has been capitalized as a cost of constructing gas distribution facilities
and the remainder is included in gas distribution operating and maintenance
expense. Net periodic benefit cost (credit) included the following components
(in millions):
Nicor Gas Company Page 8
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Notes to the Consolidated Financial Statements (Unaudited) (continued)
Pension
benefits Other benefits
--------------- ----------------
2004 2003 2004 2003
------- ------- ------- -------
Three months ended June 30
Service cost $ 2.2 $ 1.8 $ .6 $ .5
Interest cost 3.9 4.1 2.5 2.8
Expected return on plan assets (7.9) (7.2) (.2) (.3)
Recognized net actuarial loss .5 1.1 1.2 .7
Amortization of unrecognized
transition obligation - - - .8
Amortization of prior service
cost .2 .2 - -
------- ------- ------- -------
Net periodic benefit cost (credit) $(1.1) $ - $ 4.1 $ 4.5
======= ======= ======= =======
Six months ended June 30
Service cost $ 4.5 $ 3.7 $ 1.2 $ 1.0
Interest cost 7.9 8.2 5.1 5.6
Expected return on plan assets (15.9) (14.4) (.5) (.6)
Recognized net actuarial loss 1.0 2.2 2.3 1.5
Amortization of unrecognized
transition obligation - - - 1.5
Amortization of prior service
cost .3 .3 - -
------- ------- ------- -------
Net periodic benefit cost (credit) $(2.2) $ - $ 8.1 $ 9.0
======= ======= ======= =======
In 2003, the company amended the retiree health care plan as it applies to
non-unionized employees to improve consistency of benefits among participant
groups and reduce the company's share of plan costs effective January 1, 2004.
The resultant cost reduction is reflected in the 2004 net periodic benefit costs
presented above. In 2004, further cost-sharing amendments were made to the plan
for all employees. The impact of the 2004 amendments is not expected to be
material.
8. RELATED PARTY TRANSACTIONS
In the ordinary course of business, under the terms of an agreement approved by
the ICC, Nicor Gas enters into transactions with Nicor and its other wholly
owned subsidiaries for the use of facilities and services. The charges for these
transactions are cost-based, except where the charging party has a prevailing
price for which the facility or service is provided to the general public. In
addition, Nicor charges Nicor Gas and its other wholly owned subsidiaries for
the cost of corporate overheads. For the three and six months ended June 30,
2004, Nicor Gas had net charges to affiliates of $3.9 million and $8.1 million,
respectively. For the three and six months ended June 30, 2003, Nicor Gas had
net charges to affiliates of $1.1 million and $4.5 million, respectively. Also,
for the six months ended June 30, 2004, Nicor Gas recorded interest income of
$.1 million from Nicor for funds advanced during the first quarter. There were
no advances during the 2004 second quarter. For the three and six months ended
June 30, 2003, Nicor Gas recorded interest income of $.2 million and $.5
million, respectively.
Nicor Solutions, a subsidiary of Nicor, offers utility-bill management products
to customers of Nicor Gas. Under these products, Nicor Solutions pays Nicor Gas
for the utility bills issued to the utility-bill management customers. For the
three and six months ended June 30, 2004, Nicor Gas recorded revenues of $14.4
million and $49.5 million, respectively, associated with the payments Nicor
Solutions makes to Nicor Gas on behalf of its customers. For the three and six
months ended June 30, 2003, such revenues were $10.8 million and $23.6 million,
respectively.
Nicor Gas Company Page 9
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Notes to the Consolidated Financial Statements (Unaudited) (continued)
Under the terms of an ICC order, Nicor Gas routinely enters into transactions
with Nicor Enerchange, a wholesale natural gas marketing subsidiary of Nicor,
for the purchase and sale of natural gas, transportation and storage services.
For the three and six months ended June 30, 2004, net charges from Nicor
Enerchange were $3.3 million and $12.1 million, respectively, and for both the
three and six months ended June 30, 2003, net charges to Nicor Enerchange were
$1.6 million.
Horizon Pipeline, a 50-percent-owned joint venture of Nicor, charged Nicor Gas
$2.6 million and $5.3 million for the three and six months ended June 30, 2004,
respectively, for natural gas transportation under rates that have been accepted
by the Federal Energy Regulatory Commission. For the three and six months ended
June 30, 2003, Horizon Pipeline charged Nicor Gas $2.5 million and $5.1 million,
respectively, for this service.
Nicor Technologies, a subsidiary of Nicor, charged Nicor Gas $.9 million and
$1.7 million for the three and six months ended June 30, 2004, for engineering
and corrosion services. For the three and six months ended June 30, 2003, Nicor
Gas was charged $1.2 million and $2.1 million, respectively.
9. GUARANTEES AND INDEMNITIES
Financial guarantees. Nicor Gas had outstanding letters of credit and surety
bonds totaling approximately $5 million at June 30, 2004. The letters of credit
and surety bonds typically act as a guarantee of payment or performance to
certain third parties in accordance with specified terms and conditions.
Indemnities. In certain instances, Nicor Gas has undertaken to indemnify current
property owners and others against costs associated with the effects and/or
remediation of contaminated sites for which the company may be responsible under
applicable federal or state environmental laws, generally with no limitation as
to the amount. Aside from liabilities recorded in connection with coal tar
cleanup, as discussed in Note 10 Contingencies - Manufactured Gas Plant Sites,
Nicor Gas believes that the likelihood of payment under these indemnifications
is either remote or the amount would be immaterial. As such, no liability has
been recorded for these indemnifications.
Nicor Gas has also indemnified, to the fullest extent permitted under the laws
of the State of Illinois and any other applicable laws, its present and former
directors, officers and employees against expenses they may incur in connection
with litigation they are a party to by reason of their association with the
company, subject to certain limitations. It is not possible to estimate the
maximum potential payment under these indemnifications.
10. CONTINGENCIES
The following contingencies of Nicor Gas are in various stages of investigation
or disposition. Although in some cases the company is unable to estimate the
amount of loss reasonably possible in addition to any amounts already
recognized, it is possible that the resolution of these contingencies, either
individually or in aggregate, will require the company to take charges against,
or will result in reductions in, future earnings. It is the opinion of
management that the resolution of these contingencies, either individually or in
aggregate, could be material to earnings in a particular period but is not
expected to have a material adverse impact on Nicor Gas' liquidity or financial
condition.
Nicor Gas Company Page 10
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Notes to the Consolidated Financial Statements (Unaudited) (continued)
Performance-Based Rate (PBR) Plan. Nicor Gas' PBR plan for natural gas costs
went into effect in 2000 and was terminated by the company effective January 1,
2003. Under the PBR plan, Nicor Gas' total gas supply costs were compared to a
market-sensitive benchmark. Savings and losses relative to the benchmark were
determined annually and shared equally with sales customers. The PBR plan is
currently under Illinois Commerce Commission (ICC) review.
There are allegations that the company acted improperly in connection with the
PBR plan, and the ICC and others are reviewing these allegations. On June 27,
2002 the Citizens Utility Board (CUB) filed a motion to reopen the record in the
ICC's proceedings to review the PBR plan (the ICC Proceedings). As a result of
the motion to reopen, Nicor Gas, the Cook County State's Attorney Office
(CCSAO), the staff of the ICC and CUB entered into a stipulation providing for
additional discovery. The Illinois Attorney General's Office has also intervened
in this matter. In addition, the Illinois Attorney General's Office issued Civil
Investigation Demands (CIDs) to CUB and the ICC staff. The CIDs ordered that CUB
and the ICC staff produce all documents relating to any claims that Nicor Gas
may have presented, or caused to be presented, false information related to its
PBR plan. Parties who were plaintiffs in a dismissed class action proceeding
against the company could potentially intervene in these proceedings. The
company has committed to cooperate fully in the reviews of the PBR plan.
In response to these allegations, on July 18, 2002, the Nicor Board of Directors
appointed a special committee of independent, non-management directors to
conduct an inquiry into issues surrounding natural gas purchases, sales,
transportation, storage and such other matters as may come to the attention of
the special committee in the course of its investigation. The special committee
presented the report of its counsel (Report) to Nicor's Board of Directors on
October 28, 2002.
In response, the Nicor Board of Directors directed the company's management to,
among other things, make appropriate adjustments to account for, and fully
address, the adverse consequences to ratepayers of the items noted in the
Report, and conduct a detailed study of the adequacy of internal accounting and
regulatory controls. The adjustments were made in financial statements resulting
in a $24.8 million liability at June 30, 2004. Included in such $24.8 million
liability is a $4.1 million loss contingency. In addition, Nicor Gas estimates
that there is $26.9 million due to the company from the 2002 PBR plan year,
which has not been recognized in the financial statements due to uncertainties
surrounding the PBR plan. The net of these items and interest income on certain
components results in a $2.8 million reimbursement the company is seeking as of
June 30, 2004, pending resolution of the proceedings discussed below. The
company took steps to correct the weaknesses and deficiencies identified in the
detailed study of the adequacy of internal controls.
Pursuant to the agreement of all parties, including the company, the ICC
re-opened the 1999 and 2000 purchased gas adjustment filings for review of
certain transactions related to the PBR plan and consolidated the reviews of the
1999-2002 purchased gas adjustment filings with the PBR plan review.
On February 5, 2003, the CCSAO and CUB filed a motion for $27 million in
sanctions against the company in the ICC Proceedings. In that motion, CCSAO and
CUB alleged that Nicor Gas' responses to certain CUB data requests were false.
Also on February 5, 2003, CUB stated in a press release that, in addition to $27
million in sanctions, it would seek additional refunds to consumers. On March 5,
2003, the ICC staff filed a response brief in support of CUB's motion for
sanctions. On May 1, 2003, the Administrative Law Judges issued a ruling denying
CUB and CCSAO's motion for sanctions. CUB has filed an appeal of the motion for
sanctions with the ICC, and the ICC has indicated that it will not rule on
Nicor Gas Company Page 11
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Notes to the Consolidated Financial Statements (Unaudited) (continued)
the appeal until the final disposition of the ICC proceedings. It is not
possible to determine how the ICC will resolve the claims of CCSAO, CUB or other
parties to the ICC Proceedings.
In November 2003, the ICC staff, CUB, CCSAO and the Illinois Attorney General's
Office (IAGO) filed their respective direct testimony in the ICC Proceedings.
The ICC staff is seeking refunds to customers of approximately $108 million and
CUB and CCSAO were jointly seeking refunds to customers of approximately $143
million. The IAGO direct testimony alleges adjustments in a range from $145
million to $190 million. The IAGO testimony as filed is presently unclear as to
the amount which IAGO seeks to have refunded to customers. On February 27, 2004
the above referenced intervenors filed their rebuttal testimony in the ICC
Proceedings. In such rebuttal testimony, CUB and CCSAO amended the alleged
amount to be refunded to customers from approximately $143 million to $190
million. Nicor Gas filed rebuttal testimony in January 2004, which is consistent
with the findings of the special committee Report and, as noted above, seeks a
reimbursement to Nicor Gas of approximately $2.8 million. The parties to the ICC
Proceedings have agreed to a stay of the evidentiary hearings on this matter in
order to undertake additional third party discovery from Entergy-Koch Trading,
LP (EKT), a natural gas, storage and transportation trader and consultant with
whom Nicor did business under the PBR plan.
During the course of the SEC investigation discussed below, the company became
aware of additional information relating to the activities of individuals
affecting the PBR plan for the period from 1999 through 2002, including
information consisting of third party documents and recordings of telephone
conversations from EKT. The company has recently obtained access to and
reviewed this information. The company's management has determined this
information does not affect the company's previously issued financial
statements. In addition, the company's management has determined that no
adjustment to the accrual for loss contingencies in the company's second quarter
financial statements is required as a result of this information.
Although the Report of the special committee's counsel did not find that there
was criminal activity or fraud, a review of this newly available information
(which was not available to the independent counsel who prepared the Report)
and recent re-interviews of certain Nicor Gas personnel indicate that certain
Nicor Gas personnel may have engaged in potentially fraudulent conduct regarding
the PBR plan in violation of company policy, and in possible violation of SEC
rules and applicable law. Further, certain Nicor Gas personnel also may have
attempted to conceal their conduct in connection with an ICC review of the PBR
plan. The company continues to cooperate with the SEC, the U.S. Attorney's
office and the ICC on this matter and to review and produce additional documents
as requested by these agencies. The company also will review any third party
information the company obtains. The company has recently terminated four
employees in connection with this matter.
Nicor Gas is unable to predict the outcome of any of the foregoing reviews or
the company's potential exposure thereunder. Because the PBR plan and historical
gas costs are still under ICC review, the final outcome could be materially
different than the amounts reflected in the company's financial statements as of
June 30, 2004.
SEC and U.S. Attorney Inquiries. In 2002, the staff of the United States
Securities and Exchange Commission (SEC) informed the company that the SEC is
conducting a formal inquiry regarding the PBR plan. A representative of the
Office of the United States Attorney for the Northern District of Illinois has
notified the company that that office is conducting an inquiry on the same
matter that the SEC is investigating, and a grand jury is also reviewing this
matter. In April 2004, Nicor was advised by the
Nicor Gas Company Page 12
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Notes to the Consolidated Financial Statements (Unaudited) (continued)
SEC Division of Enforcement that it intended to recommend to the SEC that it
bring a civil injunctive action against Nicor, alleging that Nicor violated
Sections 17(a) of the Securities Act of 1933 and Sections 10(b) and 13(a) of
the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1 and 13a-13
thereunder. The SEC may also seek injunctive relief, disgorgement and civil
penalties. The SEC staff invited Nicor to make a formal response (known as a
Wells Submission) with respect to the proposed recommendation. In June 2004,
Nicor Gas filed its Wells Submission with the SEC. In addition, in connection
with the SEC's invitation to the company to make a Wells Submission, the SEC
informed the company of additional sources of information relating to activities
affecting the PBR plan, the status of which is addressed in detail in the
Performance-Based Rate (PBR) Plan section set forth above. Nicor Gas is unable
to predict the outcome of these inquiries or Nicor Gas' potential exposure
related thereto and has not recorded a liability associated with the outcome of
this contingency.
FERC Stipulation. On August 2, 2004, Nicor Gas entered into a settlement with
the Federal Energy Regulatory Commission (FERC) that resolves an investigation
by the Office of Market Oversight and Investigations involving the sharing of
confidential storage information with one of Nicor Gas' interstate storage
customers in violation of FERC's regulations. FERC's regulations prohibit the
provision of undue preferences among customers. There was no evidence that
Nicor Gas profited either directly or indirectly by communicating its storage
information to its customer. Under the settlement, Nicor Gas will pay a civil
penalty in the amount of $600,000, and will implement a compliance plan to
prevent similar violations in the future. The June 30, 2004 financial
statements include an accrual for this penalty.
Mercury. Nicor Gas has incurred, and expects to continue to incur, costs related
to its historical use of mercury in various kinds of company equipment.
Nicor Gas is a defendant in several private lawsuits, all in the Circuit Courts
of Cook and DuPage Counties, Illinois, claiming a variety of unquantified
damages (including bodily injury, property and punitive damages) allegedly
caused by mercury-containing regulators. Under the terms of a class action
settlement agreement, Nicor Gas will continue, until 2006, to provide medical
screening to persons exposed to mercury from its equipment, and will use its
best efforts to replace any remaining inside residential mercury regulators by
2005. The class action settlement permitted class members to "opt out" of the
settlement and pursue their claims individually. Nicor Gas is currently
defending claims brought by 30 households.
As of June 30, 2004, Nicor Gas had remaining an estimated liability of $20.9
million, representing management's best estimate of future costs, including
potential liabilities relating to remaining lawsuits, based on an evaluation of
currently available information. Actual costs may vary from this estimate. The
company will continue to reassess its estimated obligation and will record any
necessary adjustment, which could be material to operating results in the period
recorded.
Nicor Gas continues to pursue recovery from insurers and independent contractors
that had performed work for the company, but believes that it has now collected
the majority of such recoveries. When received, these recoveries are recorded as
a reduction to gas distribution operating expense. Nicor Gas recovered
approximately $18 million and $20 million of pretax mercury-related costs, net
of legal fees, from insurers and independent contractors in 2003 and 2002,
respectively. Amounts recovered during the six months ended June 30, 2004 were
immaterial.
Nicor Gas Company Page 13
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Notes to the Consolidated Financial Statements (Unaudited) (continued)
The final disposition of these mercury-related matters is not expected to have a
material adverse impact on the company's financial condition.
Manufactured Gas Plant Sites. Manufactured gas plants were used in the 1800's
and early to mid 1900's to produce manufactured gas from coal, creating a coal
tar byproduct. Current environmental laws may require the cleanup of coal tar at
certain former manufactured gas plant sites.
To date, Nicor Gas has identified about 40 properties for which it may, in part,
be responsible. Most of these properties are not presently owned by the company.
Information regarding preliminary site reviews has been presented to the
Illinois Environmental Protection Agency (IEPA) for certain properties. More
detailed investigations and remedial activities are complete, in progress or
planned at many of these sites. The results of the detailed site-by-site
investigations determine the extent additional remediation is necessary and
provide a basis for estimating additional future costs which, based on industry
experience, could be significant. In accordance with ICC authorization, the
company is and has been recovering these costs from its customers, subject to
annual prudence reviews.
In December 2001, a purported class action lawsuit was filed against Exelon
Corporation, Commonwealth Edison Company and Nicor Gas in the Circuit Court of
Cook County alleging, among other things, that the ongoing cleanup of a former
manufactured gas plant site in Oak Park, Illinois is inadequate. Since then,
additional lawsuits have been filed related to this same former manufactured gas
plant site. These lawsuits seek, in part, unspecified damages for property
damage, nuisance, and various personal injuries that allegedly resulted from
exposure to contaminants allegedly emanating from the site, and punitive
damages. Management cannot predict the outcome of this litigation or the
company's potential exposure thereto and has not recorded a liability associated
with this contingency.
In April 2002, Nicor Gas was named as a defendant, together with Commonwealth
Edison Company, in a lawsuit brought by the Metropolitan Water Reclamation
District of Greater Chicago (the MWRDGC) under the Federal Comprehensive
Environmental Response, Compensation and Liability Act seeking recovery of past
and future remediation costs and a declaration of the level of appropriate
cleanup for a former manufactured gas plant site in Skokie, Illinois now owned
by the MWRDGC. In January 2003, the suit was amended to include a claim under
the Federal Resource Conservation and Recovery Act. The suit was filed in the
United States District Court for the Northern District of Illinois. Management
cannot predict the outcome of this litigation or the company's potential
exposure thereto and has not recorded a liability associated with this
contingency.
Since costs and recoveries relating to the cleanup of manufactured gas plant
sites are passed directly through to customers in accordance with ICC
regulations, subject to an annual ICC prudence review, the final disposition of
manufactured gas plant matters is not expected to have a material impact on the
company's financial condition or results of operations.
Nicor Gas Company Page 14
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Notes to the Consolidated Financial Statements (Unaudited) (concluded)
Other. In a recent Illinois Supreme Court decision, the court affirmed the
appellate court's decision to permit proceedings to move forward against Nicor
Gas relating to a home explosion, which resulted in a fatality, allegedly caused
by a faulty gas appliance connector installed by the homeowner. Although unable
to determine the ultimate outcome of the above-referenced proceeding, the
resolution is not expected to have a material adverse impact on the company's
financial condition or results of operations. The company is unable to predict
any potential operational impact of the Illinois Supreme Court decision on
Nicor.
In addition to the matters set forth above, the company is involved in legal or
administrative proceedings before various courts and agencies with respect to
general claims, rates, taxes, environmental, gas costs prudence reviews and
other matters. Although unable to determine the ultimate outcome of these other
contingencies, management believes that it has recorded appropriate liabilities
when reasonably estimable.
Nicor Gas Company Page 15
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
The following discussion should be read in conjunction with the Management's
Discussion and Analysis section of the Nicor Gas 2003 Annual Report on Form
10-K/A (Amendment No. 1). Results for the interim periods presented are not
necessarily indicative of the results to be expected for the full fiscal year
due to seasonal and other factors.
RESULTS OF OPERATIONS
The following table provides a comparison of Nicor Gas' results as reported for
the second quarter and year-to-date periods of 2004 and 2003 (in millions):
Three months ended Six months ended
June 30 June 30
------------------- -------------------
2004 2003 2004 2003
------- --------- -------- --------
Operating income $ 13.8 $ 26.4 $ 61.0 $ 76.7
Net income 11.0 18.5 47.5 60.0
Net income decreased for both the three and six months ended June 30, 2004. For
the second quarter, the decrease was due mainly to the absence of recoveries
relating to the mercury inspection and repair program in the 2003 quarter
partially offset by an increase in property sale gains.
For the year-to-date period, the decline was due primarily to lower net
mercury-related recoveries, higher operating and maintenance expenses, and the
negative impact of warmer weather than in 2003, partially offset by increased
property sale gains.
Operating revenues. Revenues decreased in the quarter and year-to-date periods
of 2004 compared with a year ago due primarily to warmer weather. Revenues also
decreased due to lower natural gas costs, which are passed directly through to
customers without markup subject to Illinois Commerce Commission (ICC) review.
Warmer weather decreased revenues by approximately $30 million and $80 million
for the three and six months ended June 30, 2004, respectively. The revenue
effect of lower natural gas costs was $14 million and $18 million for the
three-month and six-month periods, respectively.
Nicor Gas Company Page 16
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Margin. Nicor Gas utilizes a measure it refers to as "margin" to evaluate the
operating income impact of gas distribution revenues. Gas distribution revenues
include natural gas costs, which are passed directly through to customers
without markup, subject to ICC review, and revenue taxes, for which Nicor Gas
earns a small administrative fee. These items often cause significant
fluctuations in gas distribution revenues, and yet they have virtually no direct
impact on gas distribution operating income. Therefore, Nicor Gas excludes these
items in evaluating performance. A reconciliation of gas distribution revenues
and margin follows (in millions):
Three months ended Six months ended
June 30 June 30
------------------- -----------------------
2004 2003 2004 2003
-------- --------- ----------- ----------
Revenues $ 338.4 $ 379.5 $ 1,373.5 $ 1,476.2
Cost of gas (200.5) (241.0) (992.7) (1,103.9)
Revenue tax expense (24.5) (23.9) (94.0) (85.4)
-------- --------- ----------- ----------
Margin $ 113.4 $ 114.6 $ 286.8 $ 286.9
======== ========= =========== ==========
For the quarter, margin decreased slightly due primarily to lower natural gas
deliveries due to warmer weather (approximately $2.4 million) and lower average
rates charged during the period ($1.1 million). These negative factors were
partially offset by larger contributions from the Chicago Hub ($1.5 million) and
increased natural gas deliveries unrelated to weather ($.7 million).
For the six-month period, gas distribution margin remained essentially
unchanged. Positively impacting margin were increased natural gas deliveries
unrelated to weather ($1.8 million), higher revenue tax administration fees ($.6
million), increased customer finance and late payment charges ($.6 million), and
larger contributions from the Chicago Hub ($.5 million). These positive factors
were offset by the negative impact of warmer weather than in 2003 (approximately
$3.5 million).
Operating and maintenance expense. Operating and maintenance expense remained
essentially unchanged at $54.5 million in the second quarter of 2004 versus
$54.7 million in the 2003 quarter. The $4.7 million increase in the six-month
period was due primarily to higher bad debt expense ($4.8 million), an increase
to the estimated liability for legal defense costs related to the PBR plan
review ($3 million), higher payroll costs ($2.1 million), and higher costs
related to property and casualty insurance ($1.2 million). These negative
factors were partially offset by the absence of expenses related to a 2003
service outage ($2 million), higher pension credits ($1.8 million), and the
absence of weather protection expense in 2004 ($1.4 million).
Mercury-related costs (recoveries), net. In the second quarter of 2003, Nicor
Gas recovered approximately $17.4 million of mercury-related costs, net of legal
fees, from insurers and independent contractors.
Other income (expense), net. Other income (expense) increased $3.2 million in
the second quarter of 2004 and $3 million in the year-to-date period 2004
primarily due to an increase in property sale gains ($3.1 million), net of tax.
Nicor Gas Company Page 17
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Interest expense. Interest on debt, net of amounts capitalized for the three
months ended June 30, 2004 increased $.3 million, due primarily to the impact of
higher effective interest rates, which was nearly offset by the impact of lower
average borrowing levels. Other interest expense for the three months ended June
30, 2004 decreased $2.2 million, due primarily to lower estimated interest on
income tax matters related to a favorable IRS settlement in 2004.
For the year-to-date period, interest expense, net of amounts capitalized
increased $1.7 million, due primarily to the impact of higher effective interest
rates, partially offset by the impact of lower average borrowing levels. Other
interest expense for the year-to-date period decreased $1.9 million, due
primarily to lower estimated interest expense on income tax matters.
Income taxes. The company's effective income tax rate declined to 31 percent and
35 percent for the three and six months ended June 30, 2004, respectively, from
38 percent and 37 percent for the corresponding 2003 periods. The decline in
2004 was due principally to reduced projected income, which causes a lower
effective income tax rate since permanent differences and tax credits are a
larger share of pretax income, and a favorable IRS settlement in the second
quarter of 2004.
Nicor Gas Company Page 18
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Operating Statistics
Three months ended Six months ended
June 30 June 30
------------------ --------------------
2004 2003 2004 2003
-------- -------- --------- ---------
Operating revenues (millions)
Sales
Residential $ 216.2 $ 250.5 $ 936.2 $ 1,016.3
Commercial 48.3 53.0 206.3 224.9
Industrial 5.8 6.6 28.5 33.4
-------- -------- --------- ---------
270.3 310.1 1,171.0 1,274.6
-------- -------- --------- ---------
Transportation
Residential 5.0 4.7 13.1 11.8
Commercial 13.8 14.6 38.9 40.6
Industrial 9.4 10.0 20.3 21.3
Other 2.2 4.1 7.4 9.1
-------- -------- --------- ---------
30.4 33.4 79.7 82.8
-------- -------- --------- ---------
Other revenues
Revenue taxes 25.2 24.6 96.1 86.9
Environmental cost recovery 3.3 4.0 9.9 19.7
Chicago Hub 2.6 1.1 4.0 3.5
Weather insurance - - - (3.5)
Other 6.6 6.3 12.8 12.2
-------- -------- --------- ---------
37.7 36.0 122.8 118.8
-------- -------- --------- ---------
$ 338.4 $ 379.5 $ 1,373.5 $ 1,476.2
======== ======== ========= =========
Deliveries (Bcf)
Sales
Residential 24.9 28.4 124.9 136.0
Commercial 5.8 6.3 27.4 29.7
Industrial .7 .8 3.9 4.5
-------- -------- --------- --------
31.4 35.5 156.2 170.2
-------- -------- --------- --------
Transportation
Residential 2.1 2.1 10.9 10.3
Commercial 12.3 13.4 49.7 53.1
Industrial 26.2 25.5 63.1 62.0
-------- -------- --------- --------
40.6 41.0 123.7 125.4
-------- -------- --------- --------
72.0 76.5 279.9 295.6
======== ======== ========= ========
Customers at end of period (thousands)
Sales
Residential 1,769.5 1,740.7
Commercial 115.9 111.5
Industrial 7.4 7.1
-------- --------
1,892.8 1,859.3
-------- --------
Transportation
Residential 133.9 127.5
Commercial 57.3 59.2
Industrial 6.0 6.4
-------- --------
197.2 193.1
-------- --------
2,090.0 2,052.4
======== ========
Other statistics
Degree days 591 743 3,621 3,997
Colder (warmer) than normal (12)% 10% (4)% 6%
Average gas cost per Mcf sold $ 6.28 $ 6.64 $ 6.30 $ 6.42
Nicor Gas Company Page 19
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
FINANCIAL CONDITION AND LIQUIDITY
Operating cash flows. The gas distribution business is highly seasonal and
operating cash flow may fluctuate significantly during the year and from
year-to-year due to factors such as weather, natural gas prices, the timing of
collections from customers, and natural gas purchasing and storage practices.
The company relies on short-term financing to meet seasonal increases in working
capital needs. Cash requirements generally increase over the third and fourth
quarters due to increases in natural gas purchases, gas in storage and accounts
receivable. Over the first and second quarters, positive cash flow generally
results from the sale of gas in storage and the collection of accounts
receivable. This cash is typically used to reduce short-term debt to near zero
during the second quarter. As discussed in the 2003 Form 10-K/A (Amendment No.
1), the 2003 year-end gas in storage balance was higher than a year earlier due
to an increased quantity of owned natural gas.
In the fourth quarter of 2003, Nicor Gas received an income tax refund of
approximately $100 million attributable to a tax loss carryback associated with
a change in tax accounting methods, subject to future Internal Revenue Service
review and approval. Decisions by taxing authorities may significantly impact
the company's cash flow.
Investing activities. In June 2004, Nicor Gas realized net proceeds of $7.2
million on the sale of land.
Financing activities. Nicor Gas maintains short-term line of credit agreements
with major domestic and foreign banks. These agreements, which serve as backup
for the issuance of commercial paper, allow for borrowings of up to $500 million
through September 2004. The company is currently in the process of establishing
new revolving credit facilities to replace these agreements. The company had no
commercial paper borrowings outstanding at June 30, 2004. The company is in
compliance with the covenants relating to its short-term line of credit
agreements at June 30, 2004. The company expects that funding from commercial
paper and related backup line of credit agreements will continue to be available
in the foreseeable future and sufficient to meet estimated cash requirements.
On June 29, 2004, Fitch Ratings (Fitch) downgraded Nicor Gas' First Mortgage
Bonds from AA to AA-, and affirmed Nicor Gas' commercial paper at F1+.
Contractual obligations. In addition to the long-term debt obligations reported
in the company's 2003 Annual Report on Form 10-K/A (Amendment No. 1), the
company was obligated to make related interest payments as of December 31, 2003
as follows (in millions):
Payments due by period
----------------------------------------------
Less More
Than 1 1-3 3-5 than 5
Total Year years years years
-------- ------- ------- ------- ---------
Fixed interest
on long-term debt $ 432.1 $ 30.5 $ 60.8 $ 53.7 $ 287.1
Nicor Gas Company Page 20
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
CRITICAL ACCOUNTING ESTIMATES
See Management's Discussion and Analysis - Critical Accounting Estimates in the
2003 Annual Report on Form 10-K/A (Amendment No. 1) for a detailed discussion of
the company's critical accounting policies.
FACTORS THAT MAY AFFECT BUSINESS PERFORMANCE
Weather. Natural gas deliveries are temperature-sensitive and seasonal since
about one-half of all deliveries are used for space heating. Typically, about 70
percent of deliveries and revenues occur from October through March.
Fluctuations in weather have the potential to significantly impact year-to-year
comparisons of operating income and cash flow.
In the first quarter of 2003, Nicor Gas purchased earnings protection against
the impact of significantly warmer-than-normal or colder-than-normal weather. No
such protection has been in effect since the first quarter of 2003. It is
estimated that a 100-degree-day variation from normal weather may affect Nicor
Gas' net income by about $1 million. The company continues to evaluate its
coverage options to determine whether it wishes to purchase any external weather
protection.
Operating and maintenance expenses. Operating and maintenance expenses at Nicor
Gas have increased in recent years, and it is expected that they will continue
to rise in the near future. As regulated by the ICC, base rates are designed to
allow the company an opportunity to recover its costs and to earn a fair return
for its investors. These base rates are determined as part of a rate relief
proceeding, the last of which was completed in 1996 for Nicor Gas. Nicor Gas has
the option to seek ICC approval for a base rate increase through a rate relief
proceeding, which generally takes about one year.
Labor negotiations. On April 7, 2004, Nicor Gas announced that the International
Brotherhood of Electrical Workers Local 19 ratified a new five-year labor
agreement which expires on February 28, 2009. This agreement covers
approximately 1,500 physical and clerical employees of Nicor Gas.
Property sales. Property sale gains and losses vary from year-to-year depending
upon property sales activity, and the company continues to assess its ownership
of real estate holdings.
Nicor Gas Company Page 21
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
Contingencies. The following contingencies of Nicor Gas are in various stages of
investigation or disposition. Although in some cases the company is unable to
estimate the amount of loss reasonably possible in addition to any amounts
already recognized, it is possible that the resolution of these contingencies,
either individually or in aggregate, will require the company to take charges
against, or will result in reductions in, future earnings. It is the opinion of
management that the resolution of these contingencies, either individually or in
aggregate, could be material to earnings in a particular period but is not
expected to have a material adverse impact on Nicor Gas' liquidity or financial
condition.
Performance-based rate plan. Nicor Gas' PBR plan for natural gas costs went into
effect in 2000 and was terminated by the company effective January 1, 2003.
Under the PBR plan, Nicor Gas' total gas supply costs were compared to a
market-sensitive benchmark. Savings and losses relative to the benchmark were
determined annually and shared equally with sales customers. The PBR is
currently under Illinois Commerce Commission (ICC) review.
There are allegations that the company acted improperly in connection with the
PBR plan, and the ICC and others are reviewing these allegations. On June 27,
2002 the Citizens Utility Board (CUB) filed a motion to reopen the record in the
ICC's proceedings to review the PBR plan (the ICC Proceedings). As a result of
the motion to reopen, Nicor Gas, the Cook County State's Attorney Office
(CCSAO), the staff of the ICC and CUB entered into a stipulation providing for
additional discovery. The Illinois Attorney General's Office has also intervened
in this matter. In addition, the Illinois Attorney General's Office issued Civil
Investigation Demands (CIDs) to CUB and the ICC staff. The CIDs ordered that CUB
and the ICC staff produce all documents relating to any claims that Nicor Gas
may have presented, or caused to be presented, false information related to its
PBR plan. Parties who were plaintiffs in a dismissed class action proceeding
against the company could potentially intervene in these proceedings. The
company has committed to cooperate fully in the reviews of the PBR plan.
In response to these allegations, on July 18, 2002, the Nicor Board of Directors
appointed a special committee of independent, non-management directors to
conduct an inquiry into issues surrounding natural gas purchases, sales,
transportation, storage and such other matters as may come to the attention of
the special committee in the course of its investigation. The special committee
presented the report of its counsel (Report) to Nicor's Board of Directors on
October 28, 2002. The findings of the Report include:
o Certain transactions increased customer costs in the aggregate amount of
approximately $15 million.
o No improper Nicor affiliated-party transactions or improper hedging
activities were identified.
o Inadvertent accounting errors occurred, sometimes to the benefit of customers
and sometimes to the benefit of Nicor Gas.
o No criminal activity or fraud was identified.
In response, the Nicor Board of Directors directed the company's management to,
among other things, make appropriate adjustments to account for, and fully
address, the adverse consequences to ratepayers of the items noted in the
Report, and conduct a detailed study of the adequacy of internal accounting and
regulatory controls. The adjustments were made in financial statements resulting
in a $24.8 million liability at June 30, 2004. Included in such $24.8 million
liability is a $4.1 million loss contingency. In addition, Nicor Gas estimates
that there is $26.9 million due to the company from the 2002 PBR plan year,
which has not been recognized in the financial statements due to uncertainties
surrounding the PBR plan. The net of these items and interest income on certain
components results in a $2.8 million reimbursement the company is seeking as of
June 30, 2004, pending resolution of the proceedings
Nicor Gas Company Page 22
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
discussed below. The company took steps to correct the weaknesses and
deficiencies identified in the detailed study of the adequacy of internal
controls.
Pursuant to the agreement of all parties, including the company, the ICC
re-opened the 1999 and 2000 purchased gas adjustment filings for review of
certain transactions related to the PBR plan and consolidated the reviews of the
1999-2002 purchased gas adjustment filings with the PBR plan review.
On February 5, 2003, the CCSAO and CUB filed a motion for $27 million in
sanctions against the company in the ICC Proceedings. In that motion, CCSAO and
CUB alleged that Nicor Gas' responses to certain CUB data requests were false.
Also on February 5, 2003, CUB stated in a press release that, in addition to $27
million in sanctions, it would seek additional refunds to consumers. On March 5,
2003, the ICC staff filed a response brief in support of CUB's motion for
sanctions. On May 1, 2003, the Administrative Law Judges issued a ruling denying
CUB and CCSAO's motion for sanctions. CUB has filed an appeal of the motion for
sanctions with the ICC, and the ICC has indicated that it will not rule on the
appeal until the final disposition of the ICC proceedings. It is not possible to
determine how the ICC will resolve the claims of CCSAO, CUB or other parties to
the ICC Proceedings.
In November 2003, the ICC staff, CUB, CCSAO and the Illinois Attorney General's
Office (IAGO) filed their respective direct testimony in the ICC Proceedings.
The ICC staff is seeking refunds to customers of approximately $108 million and
CUB and CCSAO were jointly seeking refunds to customers of approximately $143
million. The IAGO direct testimony alleges adjustments in a range from $145
million to $190 million. The IAGO testimony as filed is presently unclear as to
the amount which IAGO seeks to have refunded to customers. On February 27, 2004
the above referenced intervenors filed their rebuttal testimony in the ICC
Proceedings. In such rebuttal testimony, CUB and CCSAO amended the alleged
amount to be refunded to customers from approximately $143 million to $190
million. Nicor Gas filed rebuttal testimony in January 2004, which is consistent
with the findings of the special committee Report and, as noted above, seeks a
reimbursement to Nicor Gas of approximately $2.8 million. The parties to the ICC
Proceedings have agreed to a stay of the evidentiary hearings on this matter in
order to undertake additional third party discovery from Entergy-Koch Trading,
LP (EKT), a natural gas, storage and transportation trader and consultant with
whom Nicor did business under the PBR plan.
During the course of the SEC investigation discussed below, the company became
aware of additional information relating to the activities of individuals
affecting the PBR plan for the period from 1999 through 2002, including
information consisting of third party documents and recordings of telephone
conversations from EKT. The company has recently obtained access to and
reviewed this information. The company's management has determined this
information does not affect the company's previously issued financial
statements. In addition, the company's management has determined that no
adjustment to the accrual for loss contingencies in the company's second quarter
financial statements is required as a result of this information.
Although the Report of the special committee's counsel did not find that there
was criminal activity or fraud, a review of this newly available information
(which was not available to the independent counsel who prepared the Report)
and recent re-interviews of certain Nicor Gas personnel indicate that certain
Nicor Gas personnel may have engaged in potentially fraudulent conduct regarding
the PBR plan in violation of company policy, and in possible violation of SEC
rules and applicable law. Further, certain Nicor Gas personnel also may have
attempted to conceal their conduct in connection with an ICC review
Nicor Gas Company Page 23
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (continued)
of the PBR plan. The company continues to cooperate with the SEC, the U.S.
Attorney's office and the ICC on this matter and to review and produce
additional documents as requested by these agencies. The company also will
review any third party information the company obtains. The company has
recently terminated four employees in connection with this matter.
Nicor is unable to predict the outcome of any of the foregoing reviews or the
company's potential exposure thereunder. Because the PBR plan and historical gas
costs are still under ICC review, the final outcome could be materially
different than the amounts reflected in the company's financial statements as of
June 30, 2004.
SEC and U.S. Attorney Inquiries. In 2002, the staff of the United States
Securities and Exchange Commission (SEC) informed the company that the SEC is
conducting a formal inquiry regarding the PBR plan. A representative of the
Office of the United States Attorney for the Northern District of Illinois has
notified the company that that office is conducting an inquiry on the same
matter that the SEC is investigating, and a grand jury is also reviewing this
matter. In April 2004, Nicor was advised by the SEC Division of Enforcement that
it intended to recommend to the SEC that it bring a civil injunctive action
against Nicor, alleging that Nicor violated Sections 17(a) of the Securities Act
of 1933 and Sections 10(b) and 13(a) of the Securities Exchange Act of 1934 and
Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder. The SEC may also seek
injunctive relief, disgorgement and civil penalties. The SEC staff
invited Nicor to make a formal response (known as a Wells Submission) with
respect to the proposed recommendation. In June 2004, Nicor Gas filed its Wells
Submission with the SEC. In addition, in connection with the SEC's
invitation to the company to make a Wells Submission, the SEC informed the
company of additional sources of information relating to activities affecting
the PBR plan, the status of which is addressed in detail in the Performance-
Based Rate (PBR) Plan section set forth above. Nicor Gas is unable to predict
the outcome of these inquiries or Nicor Gas' potential exposure related thereto
and has not recorded a liability associated with the outcome of this
contingency.
Mercury. Future operating results may be impacted by adjustments to the
company's estimated mercury liability or by related recoveries. Additional
information about mercury contingencies is presented in the Notes to the
Consolidated Financial Statements - Note 10 Contingencies - Mercury.
Manufactured gas plant sites. The company is conducting environmental
investigations and remedial activities at former manufactured gas plant sites.
Additional information about these sites is presented in the Notes to the
Consolidated Financial Statements - Note 10 Contingencies - Manufactured Gas
Plant Sites.
FERC Stipulation. Nicor Gas entered into a settlement with the Federal Energy
Regulatory Commission (FERC). Further information about this settlement is
presented within the Notes to the Consolidated Financial Statements - Note 10
Contingencies - FERC Stipulation.
Other contingencies. The company is involved in legal or administrative
proceedings before various courts and agencies with respect to general claims,
rates, taxes, environmental, gas costs prudence reviews and other matters.
See the Notes to the Consolidated Financial Statements - Note 10 Contingencies.
Nicor Gas Company Page 24
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Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations (concluded)
Market risk. The company is exposed to market risk in the normal course of its
business operations, including the risk of loss arising from adverse changes in
natural gas commodity prices and interest rates. There has been no material
change in the company's exposure to market risk since the filing of the 2003
Annual Report on Form 10-K/A (Amendment No. 1).
CAUTION CONCERNING FORWARD-LOOKING STATEMENTS
This document includes certain forward-looking statements about the expectations
of Nicor Gas. Although Nicor Gas believes these statements are based on
reasonable assumptions, actual results may vary materially from stated
expectations. Such forward-looking statements may be identified by the use of
forward-looking words or phrases such as "anticipate," "believe," "expect,"
"intend," "may," "planned," "potential," "should," "will," "would," "project,"
"estimate," or similar phrases. Actual results may differ materially from those
indicated in the company's forward-looking statements due to the direct or
indirect effects of legal contingencies (including litigation) and the
resolution of those issues, including the effects of an ICC review and SEC and
U.S. Attorney inquiries, and undue reliance should not be placed on such
statements. Other factors that could cause materially different results include,
but are not limited to, weather conditions; natural gas prices; health care
costs; insurance costs or recoveries; legal costs; borrowing needs; interest
rates; credit conditions; economic and market conditions; energy conservation;
legislative and regulatory actions; tax rulings or audit results; asset sales;
significant unplanned capital needs; future mercury-related charges or credits;
changes in accounting principles, methods, judgments or estimates; performance
of major suppliers and contractors; labor relations; and acts of terrorism.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date of this filing. Nicor Gas undertakes
no obligation to publicly release any revision to these forward-looking
statements to reflect events or circumstances after the date of this filing.
Item 4. Controls and Procedures
The company carried out an evaluation under the supervision and with the
participation of the company's management, including its Chief Executive Officer
and Chief Financial Officer, of the effectiveness of the design and operation of
the company's disclosure controls and procedures as of the end of the period
covered by this Quarterly Report on Form 10-Q (the "Evaluation").
In designing and evaluating the disclosure controls and procedures, management
recognizes that any disclosure controls and procedures, no matter how well
designed and operated, can provide only reasonable assurance of achieving the
desired control objectives, and management is required to apply its judgment in
evaluating the cost-benefit relationship of possible disclosure controls and
procedures. Based on the Evaluation, the company's Chief Executive Officer and
Chief Financial Officer concluded that the company's disclosure controls and
procedures, as of the end of the period covered by this Quarterly Report on Form
10-Q, were effective at the reasonable assurance level to ensure that
information required to be disclosed by the company in reports that it files or
submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in SEC rules and
forms.
There has been no change in the company's internal controls over financial
reporting during the company's most recent fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the company's internal
control over financial reporting.
Nicor Gas Company Page 25
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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
See Management's Discussion and Analysis - Contingencies and the Notes to the
Consolidated Financial Statements - Note 10 Contingencies, which are
incorporated herein by reference.
Item 6. Exhibits and Reports on Form 8-K
(a) See Exhibit Index on page 27 filed herewith.
(b) On April 19, 2004, Nicor Gas filed a Form 8-K under Item 5, regarding a
press release dated April 16, 2004 announcing updates on pending legal
proceedings.
Nicor Gas Company Page 26
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Signature
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.
Nicor Gas Company
August 9, 2004 /s/ JEFFREY L. METZ
------------------- --------------------------
(Date) Jeffrey L. Metz
Vice President and Controller
(Chief Accounting Officer)
Nicor Gas Company Page 27
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Exhibit Index
Exhibit
Number Description of Document
--------- -----------------------------------------------------------
3.01 * Articles of Incorporation of the company. (File No. 1-7296,
Form 10-K for 1980, Exhibit 3-01.)
3.02 * Amendment to Articles of Incorporation of the company. (File
No. 1-7296, Form 10-Q for June 1994, Exhibit 3.01.)
3.03 * By-Laws of the company as amended by the company's Board of
Directors on January 15, 2004. (File No. 1-7296, Form 10-K for
2003, Exhibit 3.03.)
12.01 Computation of Consolidated Ratio of Earnings to Fixed Charges.
31.1 Rule 13a-14(a)/15d-14(a) Certification.
31.2 Rule 13a-14(a)/15d-14(a) Certification.
32.1 Section 1350 Certification.
32.2 Section 1350 Certification.
* These exhibits have been previously filed with the Securities and Exchange
Commission as exhibits to registration statements or to other filings with
the Commission and are incorporated herein as exhibits by reference. The file
number and exhibit number of each such exhibit, where applicable, are stated,
in parentheses, in the description of such exhibit.
Upon written request, the company will furnish free of charge a copy of any
exhibit. Requests should be sent to Investor Relations at the corporate
headquarters.