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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2002

OR

For the transition period from                              to                             

Commission file number: 1-03562

AQUILA, INC.
(Exact name of registrant as specified in its charter)

Registrant's telephone number, including area code      816-421-6600

        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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.

PART I—FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

        Information regarding the consolidated condensed financial statements is set forth on pages 3 through 19.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        Management's discussion and analysis of financial condition and results of operations can be found on pages 20 through 41.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        We are subject to market risk as described on pages 34 through 36 of our 2001 Annual Report to Shareholders. See discussion on pages 3 through 41 for changes in market risk since December 31, 2001.

PART II—OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

        Information regarding legal proceedings can be found on page 42.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

        Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

        Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS

        Information regarding the submission of matters to a vote of securities holders can be found on page 43.

ITEM 5. OTHER INFORMATION

        Information regarding executive compensation can be found on page 43.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

        Exhibits and Reports on Form 8-K can be found on page 43.

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Part I. Financial Information

Item 1. Financial Statements

Aquila, Inc.

Consolidated Condensed Statements of Income—Unaudited

See accompanying notes to consolidated condensed financial statements.

3

Aquila, Inc.

Consolidated Condensed Statements of Income—Unaudited

See accompanying notes to consolidated condensed financial statements.

4

Aquila, Inc.

Consolidated Condensed Balance Sheets

See accompanying notes to consolidated condensed financial statements.

5

Aquila, Inc.

Consolidated Condensed Statements of Comprehensive Income—Unaudited

Consolidated Condensed Statements of Common Shareholders' Equity

See accompanying notes to consolidated condensed financial statements.

6

Aquila, Inc.

Consolidated Condensed Statements of Cash Flows—Unaudited

See accompanying notes to consolidated condensed financial statements.

7

AQUILA, INC.

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

        The accompanying unaudited consolidated condensed financial statements have been prepared in accordance with the accounting policies described in the consolidated financial statements and related notes included in our 2001 Annual Report on Form 10-K/A. We believe it is best to read our year-end consolidated financial statements in conjunction with this report. The accompanying Balance Sheet and Statement of Common Shareholders' Equity as of December 31, 2001, were derived from our audited financial statements, but do not include all disclosures required by accounting principles generally accepted in the United States. In our opinion, the accompanying consolidated condensed financial statements reflect all adjustments (which include only normal recurring adjustments) necessary for a fair representation of our financial position and the results of our operations. Certain estimates and assumptions that affect reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of sales and expenses during the reporting periods shown have been made in preparing the consolidated condensed financial statements. Actual results could differ from these estimates.

        Certain prior year amounts in the consolidated condensed financial statements have been reclassified where necessary to conform to the 2002 presentation.

Change in Accounting Principle

        Effective January 1, 2002, we changed our method of accounting for our Merchant Services gas storage inventory (inventory used in daily trading activities) from the lower of cost or market method to a fair value method. This method facilitates a better matching of inventory value to the related revenues from future contract commitments that are also carried at fair value. We purchase all of our gas used in these activities from third parties and do not currently own any natural gas reserves. We calculate the fair value of this gas storage inventory using the gas daily index price for the last day of the reporting period for the applicable storage location. We had gas inventory of $36.9 million consisting of 12.4 Bcf at $2.97/mmbtu as of June 30, 2002, and $71.3 million consisting of 27.4 Bcf at $2.61/mmbtu as of December 31, 2001. This $34.4 million decrease consists of an increase of $14.9 million due to price changes offset by a decrease of $49.3 million due to sales of inventory.

        The cumulative effect of this change at January 1, 2002, was a reduction in income before income taxes of $643,000 and net income of $386,000, or less than one cent per share. The effect of this change is included in cost of sales and is not separately identified in our Statement of Income. However, had this change been in effect for the three- and six-month periods ended June 30, 2001, net income and diluted earnings per share would have been affected as follows:

8

New Accounting Pronouncements

Goodwill and Other Intangible Assets

        On January 1, 2002, we were required to adopt Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets" (SFAS 142). SFAS 142 requires that goodwill no longer be amortized to expense. Rather, this statement requires that goodwill be tested for impairment at least annually and, if impaired, be written off against earnings at that time. We have completed an initial assessment of the realizability of our goodwill and have determined that as of January 1, 2002, no goodwill impairments existed.

        At June 30, 2002, we had total gross goodwill of $508.4 million, or $471.6 million net of accumulated amortization, including $73.3 million of goodwill on investments in unconsolidated subsidiaries. Amortization expense for the three- and six-month periods ended June 30, 2001 totaled $6.2 million and $12.3 million, respectively. In addition, our earnings from equity method investments included $4.4 million and $8.8 million of amortization expense, for the three- and six-months ended June 30, 2001, respectively.

        As discussed in Note 5 "Exchange Offer", $216.6 million of goodwill was recorded in the repurchase of Aquila Merchant Services, Inc. on January 7, 2002. We allocated $175.0 million of this goodwill to our Wholesale Services segment and $41.6 million to our Capacity Services segment based upon future expected cash flows. As a result of our second quarter decision to exit the wholesale energy trading business, we determined that all of the goodwill in our Wholesale Services business was impaired. Therefore, we recorded an impairment charge of $178.6 million. In addition, as further discussed in Note 3, we recorded an impairment charge related to our investment in Quanta Services, Inc. of $692.9 million, which included a $328.0 million goodwill impairment charge related to this investment.

        Our goodwill allocated to each segment at June 30, 2002 and December 31, 2001 is as follows:

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        Following are disclosures of net income and earnings per share for the three- and six-month periods ended June 30, 2001, had SFAS 142 been in effect at the beginning of those periods:

Asset Retirement Obligations

        In August 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, "Accounting for Asset Retirement Obligations" (SFAS 143). SFAS 143 requires companies to record the fair value of a liability for an asset retirement obligation in the period in which the liability is incurred. When the liability is initially recorded, we will include the present value of the estimated cost of removal in the asset cost, with an offsetting liability related to the estimated cost of removal. The liability will be increased to the nominal value over time. Upon settlement of the liability, we will record a gain or loss for the difference between the settled liability and the recorded amount. This standard will become effective for us on January 1, 2003. We are in the process of assessing the impact that the adoption of this standard will have on our financial position and results of operations.

Energy Trading Activities

        In June 2002, the Emerging Issues Task Force (EITF) reached a consensus on a topic discussed in EITF No. 02-3, "Recognition and Reporting of Gains and Losses on Energy Trading Contracts under EITF No. 98-10, "Accounting for Contracts Involved in Energy Trading Risk Management Activities"'. EITF No. 02-3 states that all mark-to-market gains and losses on energy trading contracts should be shown net on the income statement whether or not they are settled physically. This statement also discusses the issue of whether the recognition of unrealized gains and losses at the inception of an energy trading contract is appropriate. The Task Force did not reach a consensus on this issue and referred this issue to a working group. EITF No. 02-3 also lists specific disclosures to be included in the financial statements of entities involved in energy trading activities. This statement becomes effective for us for the quarter ended September 30, 2002. EITF No. 02-3 will have no impact on our gross profit or net income in our financial statements, however, it will reduce our sales and cost of sales.

Costs Associated with Exit or Disposal Activities

        On July 30, 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities" (SFAS 146). This standard requires companies to recognize certain costs associated with exit or disposal costs when they are incurred rather than at the date of a commitment to an exit or disposal plan. The primary effect of applying SFAS 146 will be on the timing of recognition of costs associated with exit or disposal activities. In many cases, those costs will only be recognized as liabilities in periods following a commitment to a plan, not at the date of the commitment. SFAS 146 is to be applied prospectively to exit or disposal activities initiated after December 31, 2002.

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2. Restructuring Charges

        We re-aligned our Domestic Networks Group to more closely align itself with its regulatory service areas and our Merchant Services group to focus on its core products and services. This resulted in a reduction of approximately 700 positions and the exit from our corporate air travel service. This reduction in employees consisted of approximately 150 Merchant Services employees, 50 Corporate employees, and 500 Domestic Networks employees.

        Due to the increased credit requirements necessary to operate our wholesale energy trading business, we announced on June 17, 2002, our plans to reduce our risk exposure through the elimination of all proprietary trading and market making activities. Because of this decision, we began to wind down our wholesale energy trading operations, while we preserved the business infrastructure for a possible sale or joint venture arrangement with a third party. This decision led to the termination of approximately 370 employees of the wholesale energy trading business and a plan to terminate an additional 320 employees as the trading operations are wound down.

        As a result of these actions, we recorded restructuring charges of $71.8 million in the second quarter that consisted of the following:

        Involuntary termination costs were accrued and charged to expense in the quarter, but will be paid bi-weekly over the term of the severance benefit. The amount of termination benefits paid as of June 30, 2002, was $1.4 million, resulting in a remaining liability of $39.3 million. We also wrote-down certain leasehold improvements and equipment in our wholesale energy trading business that were no longer realizable based on management's best estimate of their fair value. The disposition of the corporate air travel service primarily included the termination of applicable lease agreements and losses associated with the sale of our corporate aircraft.

        On August 6, 2002, we concluded that a sale or partnership of our wholesale energy trading business was not going to occur, thus we announced that we would completely exit this business and shut down the operations by September 30, 2002. We expect to terminate up to an additional 275 employees and incur additional severance of approximately $10.8 million in the third quarter because of this decision. Certain employees of the wholesale energy trading operations have retention agreements to ensure an orderly exit of the business by September 30, 2002. These agreements obligate us to pay these employees approximately $26.8 million if they remain employed by us until released. We also have operating leases for various office facilities used in the wholesale energy trading operations with future lease commitments of $58.5 million. We are in the process of evaluating the future use, sublease or termination of these agreements. In connection with the exit of this business, we expect to incur additional losses on the liquidation of our outstanding trading contracts.

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3. Impairment Charges

        In the second quarter of 2002 we recorded the following impairment charges:

Quanta

        At June 30, 2002, our cost basis in our 38% owned investment in Quanta of approximately $26.69 per share was significantly above the trading price of Quanta's stock. On July 1, 2002, Quanta announced that it had reduced its earnings forecast due to a continued decline in the telecommunications industry, reduced utility construction spending, and the financial difficulties of Quanta's two largest customers. Quanta's share price had dropped to approximately $3 per share after this announcement. Because of these factors, and the termination of our proxy contest for control of Quanta in May 2002, we concluded that there was an other than temporary decline in the fair value of this investment. Accordingly, we have written the investment down to its estimated fair value of $3 a share, or $87.7 million in total.

        In late July 2002, we sold approximately 5.5 million shares of Quanta stock at an average price of $2.05 per share, reducing our ownership percentage from 38% to approximately 31%.

Wholesale Services

        In connection with our decision to exit our energy trading operations, we assessed our ability to realize the goodwill associated with our Wholesale Services business. This assessment was based on our best estimate of the value of this business in a liquidation, which we determined was less than the carrying value of its net assets. Because future earnings or sufficient sales proceeds could no longer support this asset, we wrote off the entire unamortized goodwill balance.

Communications Technology Investments

        During the quarter ended June 30, 2002, we determined that certain cost and equity method investments in communications technology-related businesses were impaired based on continuing losses in these businesses, their continued failure to achieve operational goals, the inability of these businesses to obtain additional capital, and our assessment of the long-term prospects of these businesses. Accordingly, we wrote-off $23.1 million of these investments.

4. Earnings (Loss) per Common Share

        The following table shows the amounts used in computing basic and diluted earnings (loss) per common share and the effect on income and weighted average number of shares of potential dilutive issuances of common stock for the three- and six-month periods ended June 30, 2002 and 2001. As a

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result of the net loss for the three-month and six-month periods ended June 30, 2002, the potential issuances of common stock were anti-dilutive and therefore not included in those periods.

5. Financings, Mergers, Acquisitions and Divestitures

Exchange Offer

        On January 7, 2002, we completed an offer to acquire all of the outstanding publicly held shares of Aquila Merchant Services, Inc. (Aquila Merchant) in exchange for shares of Aquila common stock. The public shareholders of Aquila Merchant received .6896 shares of Aquila common stock in a tax-free exchange for each outstanding share of Aquila Merchant Class A common stock. Approximately 76% of the outstanding public shares of Aquila Merchant were tendered in the offer. Aquila Merchant shareholders holding approximately 1.8 million shares of Aquila Merchant Class A shares exercised dissenters' rights with respect to the merger.

        We accounted for this transaction as a purchase. The total purchase price of $367.6 million was determined based upon the market price of the approximately 12.6 million Aquila common shares issued in the tender offer and merger, an estimated liability to dissenting shareholders at the same market price and transaction costs. The purchase price was in excess of our proportionate interest in the fair value of the net assets of Aquila Merchant acquired by approximately $216.6 million. This excess was classified as goodwill and allocated as $175.0 million to our Wholesale Services segment and $41.6 million to our Capacity Services segment based on expected future cash flows. Due to our decision to exit the wholesale energy trading operations, we subsequently wrote-off the goodwill that was allocated to the Wholesale Services segment based upon the lack of expected future cash flows.

13

Equity and Senior Notes Offerings

        On January 30, 2002, we sold 12.5 million shares of our common stock to the public at a price of $23 per share, which raised approximately $277.7 million in net proceeds. Net proceeds from the sale were used to reduce short-term debt and for general corporate purposes.

        On February 28, 2002, we issued $287.5 million of 7.875% senior notes due in February 2032. These bonds are callable by us at par after February 28, 2007. Net proceeds from the sale were used to replace liquidity of $220 million previously provided from receivables sold in connection with one of our accounts receivable sales programs and to retire short-term debt incurred for general corporate purposes.

        On July 3, 2002, we completed our concurrent offerings of 37.5 million shares of our common stock to the public at a price of $7.50 per share and $500 million of 11.875% senior unsecured notes due in July 2012, raising total proceeds of approximately $764 million. We used the proceeds from these offerings to repay $417 million of borrowings under the revolving credit facility, to retire $100 million of current maturities of company-obligated preferred securities and to increase liquidity. Accordingly, we have reclassified $500 million of those current obligations into long-term debt as of June 30, 2002.

Sale of Pipeline Operations

        In January 2002, we completed the sale of an intrastate pipeline for our net book value of approximately $65.9 million, including a $5 million deposit received in 2001.

Midlands Electricity Acquisition

        On May 8, 2002, we completed our purchase of a 79.9% economic interest in Midlands Electricity plc, a United Kingdom electricity network, from FirstEnergy Corp. The gross price of this acquisition was approximately $262 million. The purchase price consists of an initial payment of $155 million, which was financed through a short-term acquisition facility, transaction costs of $19 million, and an $88 million present value obligation to be paid in six equal annual payments of $19 million each. Midlands Electricity is the fourth-largest regional electricity company in the United Kingdom, serving approximately 2.3 million customers through a 38,000-mile distribution network. Midlands Electricity also owns 886 megawatts of net generating capacity in the U.K., Turkey and Pakistan. Pursuant to an operating services agreement, we will provide management and operating services to Midlands Electricity in exchange for a management fee.

        In connection with the acquisition, FirstEnergy retained substantive participating and protective rights as the minority partner. We and FirstEnergy each have 50% voting power and, an equal number of representatives on the Midlands Electricity board. Although we have the majority economic interest, FirstEnergy's participation in the ordinary course of business decisions is significant; including, approval of senior management compensation, additional capital contributions, distributions other than as provided in the agreement, budgets and financial plans and the dissolution of the company. As such, we are required to account for this acquisition using the equity method of accounting. FirstEnergy has the right to sell its interest in Midlands Electricity to us at fair market value if, at any time during the 30-day period prior to the sixth anniversary of closing, the fair value of its holdings is less than $72.8 million.

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        A summary income statement for Midlands Electricity for the year ended December 31, 2001 is as follows:

        On August 7, 2002, we announced that we intend to initiate a bid process for the sale of our interest in Midlands Electricity. This decision was made in light of our program to target $1 billion in asset sales and in response to interest by others in our investment.

Cogentrix Transaction Termination

        On August 2, 2002, we agreed to terminate our purchase agreement signed in April 2002, to acquire Cogentrix Energy, Inc., a leading independent power producer. We agreed with Cogentrix that due to the current uncertainty of the electric power market, proceeding with the transaction was impractical and not in either company's best interest.

New Zealand

        On June 11, 2002, UnitedNetworks Limited (UNL), in which we have a 55.5% interest, announced plans to seek buyers for the assets or stock of the company. UNL received indicative bids in late July with final binding bids to be submitted in late August. Subject to the receipt of acceptable bids and the execution of a purchase agreement, closing is expected to occur in the fourth quarter of 2002. Our net investment in our New Zealand network was $357 million at June 30, 2002.

Sale of Pulse Energy

        On July 2, 2002, we announced that United Energy and Multinet Gas had reached an agreement to sell their combined 50% interest in Pulse Energy, a retail electricity and gas company. Through our 34% ownership in United Energy and our 25.5% ownership in Multinet Gas, we have an approximate 15% ownership in Pulse. United Energy also announced the sale of its interests in EdgeCap, a marketing and trading business, and Utili-Mode, a provider of back office support services for United Energy and others. The sales of these three businesses are expected to close in the third quarter and result in a small gain to us.

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Power Plant Lease

        In February of 2002, we entered into an agreement to lease, from a special purpose entity, a $235 million, 510-megawatt power plant, currently under construction. We expect construction to be completed in April 2003. The lease is a 5-year operating lease that begins once construction is completed. Under certain conditions, we guarantee up to 89.99% of the construction costs prior to completion. As of June 30, 2002, $132.4 million of construction costs had been funded. We are required to cash collateralize construction costs funded in excess of $128.6 million. We also provide a guarantee that the residual value at the end of the lease will equal at least 83% of construction costs.

Sale of Katy Storage

        On August 8, 2002, we signed an agreement to sell our Texas natural gas storage operations for approximately $180 million. This transaction is subject to regulatory review under the Hart-Scott-Rodino Act which is expected to be completed within 60 days, and other pre-conditions to closing. We expect to realize a small gain on this sale.

6. Finance Subsidiaries' Securities

        Aquila Networks Canada Finance Corporation and UtiliCorp Capital Trust I are wholly owned consolidated finance subsidiaries of Aquila. We have fully and unconditionally guaranteed the $200 million of long-term debt and $250 million of company-obligated preferred securities issued by these subsidiaries, respectively.

7. Reportable Segment Reconciliation

*

Gain on the sale of Aquila Merchant Services shares by Aquila in 2001.

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8. Credit Facilities

Revolving Credit Agreement

        On April 12, 2002, we entered into a new revolving credit facility totaling $650 million that replaced a $400 million credit facility. The new credit facility consists of two $325 million agreements, one with a maturity date of 364 days, the other three years. As of June 30, 2002, $417.0 million of borrowings were outstanding under this facility in addition to $82.8 million of letters of credit. The borrowings were repaid in July 2002, with the proceeds from our common stock and senior note offerings. Among other restrictions, the agreements contain financial covenants requiring a ratio of recourse debt to total recourse capitalization of .625 to 1.0, and an interest coverage ratio (EBITDA / Interest expense) of not less than 2.25 to 1.0. These covenants exclude non-cash gains or losses when calculating EBITDA. We are currently in compliance with these covenants.

Debt Covenants

        In 2001, our subsidiary, Aquila Merchant, issued two separate guarantees to support the financing of a power generation facility and a gas storage facility. The two guaranties require Aquila Merchant to meet certain financial covenants, one being a fixed charge coverage ratio, which is calculated on a rolling twelve-month basis. For the covenant calculation period ended March 31, 2002, Aquila Merchant was not in compliance with this fixed charge coverage ratio. We obtained waivers dated May 10, 2002, and May 13, 2002, from the lenders for the non-compliance covering the period ended March 31, 2002. One of the waivers required a $72,500 administrative fee paid to the beneficiaries of the guarantee, while the other was provided at no additional cost. The Aquila Merchant guarantees have now been replaced with Aquila guarantees that require the same financial covenants as our revolving credit facility discussed above.

        Our debt arrangements include syndicated bank debt, uncommitted bank lines, a commercial paper program, an accounts receivable sales program, bonds (secured and unsecured), and financial guarantees that support subsidiary financings. The syndicated bank debt, most bonds outstanding, and financial guarantees contain cross-default provisions, which are usual and customary for these types of arrangements.

Current Credit Ratings

        Credit ratings impact our ability to obtain short and long-term financing, the cost of such financing and the execution of our commercial strategies. Our financial flexibility is likewise dependent on the absence of restrictive covenants and other terms that are typically imposed on non-investment grade

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borrowers. As of August 12, 2002, our senior unsecured long-term debt ratings, as assessed by the three major credit rating agencies, were as follows:

        Our credit ratings were placed under review for possible downgrade by S&P on April 23, 2002, and by Moody's on May 30, 2002. The reasons given by the ratings agencies included our announced acquisition of Cogentrix Energy, risks associated with our foreign investments, concerns that we lacked the financial resources to support our energy trading operations and an analysis of our operations under more stringent credit metrics. Since that time we have taken the following actions:

•

Terminated the Cogentrix acquisition;



•

Reduced our dividend by 42%;



•

Exited from wholesale energy trading;



•

Targeted over $1 billion in asset sales in which we have signed sale agreements totaling $218 million and publicly announced bid processes for the sale of our investments in UNL and Midlands. In addition, we have active bid processes for a number of other assets;



•

Completed equity and debt offerings totaling $764 million in proceeds;



•

Targeted over $100 million in cost reductions, the majority of which have already been achieved.

        Our management is currently in discussions with representatives of Moody's, S&P and Fitch. However, we cannot predict the actions, if any, that may be taken by the credit rating agencies subsequent to these meetings.

Ratings Triggers

        Our credit agreements, debt instruments and other financial obligations provide that the occurrence of certain events could (if not cured) require early payment, additional collateral support or similar actions. These events include the failure to achieve leverage ratios, insolvency events, defaults on scheduled principal or interest payments, acceleration of other financial obligations and a change of control. We are currently in compliance with covenants or other provisions relating to these events. We do not have any trigger events tied to our stock price and have not executed any transactions that require us to issue equity based on our credit ratings or other trigger events.

        Certain of our subsidiaries have trigger events tied to specified credit ratings. Because of guarantee and cross default provisions between Aquila, Inc. and these subsidiaries, the ratings triggers of our subsidiaries discussed below should be viewed as if they are directly applicable to Aquila, Inc. Our Australian subsidiaries have issued six series of Australian denominated bonds, guaranteed by us, that contain provisions that could require us to repurchase the bonds. The put right for two series aggregating approximately $85 million can be exercised 30 days after a downgrade to non-investment grade by either S&P or Moody's. Those series mature in October 2002. The put right for the other four series aggregating approximately $92 million can be exercised on the next scheduled interest payment date if we are rated below investment grade by S&P.

        Our Merchant Services subsidiary also has three "tolling agreements," a construction loan and certain margining agreements that have trigger events tied to Aquila's credit ratings. Under the tolling agreements, our subsidiary uses a third party's generation assets to convert fuel into electric power for its subsequent resale. The maximum aggregate amount of collateral that it could be required to post in the event of a ratings trigger under these contracts is approximately $172 million. Of this amount, $45 million must be posted within 10 days of a downgrade below investment grade by either Moody's

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or S&P; $37 million must be posted within 70 days of the date we are rated below investment grade by both Moody's and S&P; and $28 million under the construction loan must be posted within 10 business days of a downgrade below investment grade by both S&P and Moody's. We expect the trigger under the construction loan will terminate upon the completion of construction and permanent project financing in late September 2002. We also have certain standard margining agreements that would require collateral of $62 million if we were downgraded below investment grade. These potential collateral requirements are expected to decline as we exit the wholesale energy trading business over the next two months.

Other Potential Demands for Collateral

        Although we are in the process of exiting the energy trading operations of our Merchant Services subsidiary, a substantial number of energy trading agreements remain to be settled. The majority of these contracts will be settled within the next two months. These contracts typically include provisions which allow counterparties the right to request additional collateral or suspend or terminate credit if events occur that cause counterparties to feel that there has been a deterioration in our underlying credit. In connection with our exit from the wholesale energy trading business, we have identified key commercial relationships that will be important to our ongoing business. If a downgrade were to occur, those relationship companies could potentially demand collateral support for ongoing and future activity. While it is difficult to predict how many parties would successfully demand some form of collateral, we currently estimate that the amount of cash collateral would be no more than $135 million. We expect that potential claims on liquidity will be further reduced as we exit our wholesale energy trading business over the next two months.

Legal Proceeding

        On February 19, 2002, we filed a suit against Chubb Insurance Group, the issuer of surety bonds in support of certain of our long-term gas supply contracts. Previously, Chubb had demanded that it be released from its up to $561 million surety obligation or, alternatively, that we post collateral to secure its obligation. We do not believe that Chubb is entitled to be released from its surety obligations or that we are obligated to post collateral to secure its obligations unless it is likely we will default on the contracts. Chubb has not alleged that we are likely to default on the contracts. If Chubb were to prevail, it would have a material adverse impact on our liquidity and financial position. We have performed under the contracts since their inception and believe we will be able to continue to perform on the contracts and that we will prevail in the action. We rely on other suretys in support of long-term gas supply contracts similar to those described above. There can be no assurance that these suretys will not make claims similar to those raised by Chubb.

9. Income Taxes

        The second quarter 2002 income tax benefit was reduced primarily as a result of two factors. First, the tax benefit from the $692.9 million pre-tax write-down of our investment in Quanta Services is limited to available capital gains in the preceding three years and subsequent five years. Because capital gains within the carryback period were less than the loss and significant capital gains could not be assured in the foreseeable future, a $201 million valuation allowance was established. Second, the $178.6 million impairment charge related to Wholesale Services goodwill is considered a permanent difference between book and taxable income and does not result in the recognition of a tax benefit. These adjustments have had a significant impact on the 2002 effective tax rate for both the quarter and six months ended June 30, 2002.

10. Reduction of Dividend

        On June 17, 2002, we announced that, going forward, our Board of Directors expected to reduce the quarterly dividend to $.175 per share, or $.70 per share annually, down from the prior quarterly dividend of $.30 per share, or $1.20 per share annually. This decision was made in connection with our decision to scale back the wholesale energy trading business and was influenced by, among other things, decreased earnings, a substantial increase in the number of outstanding shares, and the Company's credit concerns. On August 7, 2002, our Board of Directors declared a dividend of $.175 per share. The record date for the dividend is August 22, 2002, and the dividend is payable on September 12, 2002.

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

AQUILA, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

        Except where noted, the following discussion refers to the consolidated entity, Aquila, Inc. Although we recently announced our exit from our Wholesale Services business, during the periods covered by this report, our businesses were structured as follows: (a) Merchant Services, consisting primarily of two segments, (i) Wholesale Services, our North American and European commodity and client services businesses (including our capital business), and (ii) Capacity Services, our power development, natural gas gathering and processing operations, and investments in independent power projects, and (b) Global Networks Group, consisting of two segments, (i) International Networks, our Canadian, Australian, United Kingdom and New Zealand electricity and gas utility businesses, and (ii) Domestic Networks, our electricity and gas utilities in seven mid-continent states. Domestic Networks also includes our communications business and our investment in Quanta Services, Inc.

FORWARD-LOOKING INFORMATION AND RISK FACTORS

        This report contains forward-looking information. These statements involve risks and uncertainties, and there are certain important factors that can cause actual results to differ materially from those anticipated. We generally intend the words "may", "will", "should", "expect", "anticipate", "intend", "plan", "believe", "seek", "estimate", "continue", or the negative of these terms or similar expressions to identify forward-looking statements. Similarly, statements that describe our objectives, plans and goals may be forward-looking statements. Some of the important factors and risks that could cause actual results or liquidity to differ materially from those anticipated include:

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Both our Global Networks Group and Merchant Services businesses are weather-sensitive. Weather can affect results significantly to the extent that temperatures differ from historical averages.



•

We are exposed to market risk on open positions on our trading contracts, which may cause us to incur losses from our Wholesale Services operations.



•

A downgrade of any of our credit ratings below investment grade could have a material adverse effect on our liquidity.



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We may not be able to profitably operate our business if we are unable to access or generate capital at competitive rates.



•

The timing and extent of changes in interest rates will affect our financial results.



•

Our continued ability to draw on our corporate revolver is a significant factor in the company's overall liquidity.



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We may not be able to obtain attractive prices for planned asset sales.



•

The volatility of natural gas and electricity prices will significantly affect the earnings contribution from Capacity Services.



•

The pace of well connections to our gas gathering system can affect the earnings contribution from the Capacity Services segment of Merchant Services.



•

The pace and degree of regulatory changes in the U.S. and abroad can affect existing and new business opportunities and the intensity of competition.

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•

The value of the U.S. dollar relative to the British pound, Canadian dollar, Australian dollar and New Zealand dollar can affect financial results from our foreign operations.



•

The inability to pass through increased fuel and purchased power costs to our customers in certain regulatory jurisdictions may affect the results of operations of our Global Networks Group.



•

The modification of regulations or historical practices in those jurisdictions in which we rely upon our ability to recover our costs from our customers could adversely affect our earnings.



•

The result of rate proceedings will affect future earnings of our Global Networks Group.



•

The construction of communications fiber optic networks and start-up operations of our communications business will have a negative effect on cash flows and earnings over the near term.



•

We expect to incur losses from the liquidation and/or termination of contracts as we exit the wholesale energy trading business.

RESULTS OF OPERATIONS

Executive Summary

        This review of performance is organized by business segment, reflecting the way we managed our business during the periods covered by this report. Each business leader is responsible for operating results down to earnings before interest and taxes (EBIT), as corporate management is responsible for making all financing decisions. Therefore, each segment discussion focuses on the factors affecting EBIT, while financing and income taxes are separately discussed at the corporate level.

        We use the term "Operating EBIT" to describe our recurring earnings before interest and taxes excluding items we deem to be non-recurring. We have found that this helps our investors get a clearer view on what to expect on a normal recurring basis. The term is not meant to replace actual EBIT, or be considered as an alternative to net income or cash flows from operating activities, which are determined in accordance with generally accepted accounting principles (GAAP), as an indicator of operating performance or as a measure of liquidity, or other performance measures used under GAAP. In addition, the term may not be comparable to similarly titled measures used by other entities.

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