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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
(Mark one)
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 0-15472
Environmental Power Corporation
(Exact name of registrant as specified in its charter)
Delaware 04-2782065
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
One Cate Street 4th Floor, Portsmouth, New Hampshire 03801
(Address of principal executive offices)
(Zip code)
(603) 431-1780
Registrant's telephone number, including area code
- -------------------------------------------------------------------------------
(Former name, former address and former fiscal year,
if changed since last report)
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 |X| No |_|
Number of shares of Common Stock outstanding
at August 14, 2002 21,453,109 shares
The Exhibit Index appears on Page 36.
Total number of pages is 37.
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ENVIRONMENTAL POWER CORPORATION
INDEX
PART I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as
of June 30, 2002 (unaudited) and December 31, 2001 ......... 2
Condensed Consolidated Statements of Operations
(unaudited) for the Three and Six Months Ended
June 30, 2002 and June 30, 2001 ............................ 3
Condensed Consolidated Statements of Cash Flows
(unaudited) for the Six Months Ended June 30, 2002
and June 30, 2001 .......................................... 4
Notes to Condensed Consolidated Financial
Statements ................................................. 5-8
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations .............. 8-33
Item 3. Quantitative and Qualitative Disclosures
About Market Risk .......................................... 33-34
PART II. OTHER INFORMATION
Item 5. Other Information .................................. 35
Item 6. Exhibits and Reports on Form 8-K ................... 36
Signatures ................................................. 37
1
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
June 30 December 31
2002 2001
----------------- ----------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 879,309 $ 468,271
Restricted cash 1,588,257 1,014,580
Receivable from utility 5,978,823 7,905,864
Other current assets 912,946 607,590
----------------- ----------------
TOTAL CURRENT ASSETS 9,359,335 9,996,305
PROPERTY, PLANT AND EQUIPMENT, NET 1,380,057 652,830
LEASE RIGHTS, NET 2,087,001 2,161,503
ACCRUED POWER GENERATION REVENUES 66,920,989 63,648,995
GOODWILL 4,912,866 4,912,866
LICENSED TECHNOLOGY RIGHTS, NET 3,536,189 3,628,177
OTHER ASSETS 544,343 565,570
----------------- ----------------
TOTAL ASSETS $ 88,740,780 $ 85,566,246
================= ================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 8,276,399 $ 9,382,471
Secured promissory note payable to related party 750,000 750,000
Other current liabilities 2,466,358 1,363,108
----------------- ----------------
TOTAL CURRENT LIABILITIES 11,492,757 11,495,579
DEFERRED GAIN, NET 4,317,750 4,471,955
SECURED PROMISSORY NOTES PAYABLE
AND OTHER BORROWINGS 1,383,148 1,420,467
DEFERRED INCOME TAX LIABILITY 228,115 146,396
ACCRUED LEASE EXPENSES 66,920,989 63,648,995
----------------- ----------------
TOTAL LIABILITIES 84,342,759 81,183,392
----------------- ----------------
SHAREHOLDERS' EQUITY:
Preferred Stock ($.01 par value; 2,000,000 shares authorized as of
June 30, 2002 and December 31, 2001; no shares issued) 0 0
Preferred Stock (no par value, 10 shares authorized; 10 shares
issued as of June 30, 2002 and December 31, 2001) 100 100
Common Stock ($.01 par value; 50,000,000 shares authorized;
21,370,293 issued; and 20,251,653 outstanding as of
June 30, 2002 and December 31, 2001) 213,702 213,702
Additional paid-in capital 6,897,253 6,850,046
Accumulated deficit (1,494,247) (1,518,390)
Accumulated other comprehensive loss (60,385) (60,385)
----------------- ----------------
5,556,423 5,485,073
Treasury stock (1,118,640 common shares, at cost, as of
June 30, 2002 and December 31, 2001) (512,454) (456,271)
Notes receivable from officers and board members (645,948) (645,948)
----------------- ----------------
TOTAL SHAREHOLDERS' EQUITY 4,398,021 4,382,854
----------------- ----------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 88,740,780 $ 85,566,246
================= ================
See Notes to Condensed Consolidated Financial Statements.
2
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended June 30 Six Months Ended June 30
2002 2001 2002 2001
---------------- --------------- --------------- ----------------
POWER GENERATION REVENUES $ 11,977,205 $ 12,096,878 $ 26,090,461 $ 25,579,769
---------------- --------------- --------------- ----------------
COSTS AND EXPENSES:
Operating expenses 7,469,811 7,529,833 12,614,544 12,487,073
Lease expenses 6,291,677 5,859,101 13,075,057 11,874,123
General and administrative expenses 976,662 802,751 2,334,541 1,488,480
Depreciation and amortization 136,689 86,564 272,660 173,111
---------------- --------------- --------------- ----------------
14,874,839 14,278,249 28,296,802 26,022,787
---------------- --------------- --------------- ----------------
OPERATING LOSS (2,897,634) (2,181,371) (2,206,341) (443,018)
---------------- --------------- --------------- ----------------
OTHER INCOME (EXPENSE):
Interest income 12,479 22,960 22,032 41,744
Interest expense (40,062) (33,124) (70,561) (102,427)
Amortization of deferred gain 77,102 77,102 154,205 154,205
Sales of NOx emission credits 0 --- 2,428,200 ---
Other income 859 1,677,962 2,859 1,677,962
---------------- --------------- --------------- ----------------
50,378 1,744,900 2,536,735 1,771,484
---------------- --------------- --------------- ----------------
(LOSS) INCOME BEFORE INCOME TAXES (2,847,256) (436,471) 330,394 1,328,466
INCOME TAX BENEFIT (EXPENSE) 1,104,749 219,000 (306,251) (558,000)
---------------- --------------- --------------- ----------------
NET (LOSS) INCOME $ (1,742,507) $ (217,471) $ 24,143 $ 770,466
================ =============== =============== ================
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING:
Basic 20,038,591 11,406,783 20,144,423 11,406,783
Diluted 20,159,583 11,406,783 20,216,663 11,406,783
EARNINGS PER COMMON SHARE:
Basic $ (0.09) $ (0.02) $ 0.00 $ 0.07
Diluted $ (0.09) $ (0.02) $ 0.00 $ 0.07
See Notes to Condensed Consolidated Financial Statements.
3
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months Ended June 30
2002 2001
---------------- ----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 24,143 $ 770,466
Adjustments to reconcile net income to net cash
Provided by operating activities:
Depreciation and amortization 272,660 173,111
Deferred income taxes 81,719 98,000
Amortization of deferred gain (154,205) (154,205)
Stock Based Compensation 49,707
Accrued power generation revenues (3,271,994) (3,730,422)
Accrued lease expenses 3,271,994 3,730,422
Changes in operating assets and liabilities:
Decrease (Increase) in receivable from utility 1,927,041 1,235,085
Decrease (increase) in other current assets (318,664) (718,126)
Increase in other assets 3,407 (5,003)
(Decrease) increase in accounts payable and
accrued expenses (2,821) 1,775,116
Increase (Decrease) in long-term debt to supplier 0 (96,274)
---------------- ----------------
Net cash provided by operating activities 1,882,987 3,078,170
---------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Increase in restricted cash (573,677) (626,388)
Acquisition related expenditures (199,702)
Property, plant and equipment expenditures (802,270) (1,000)
---------------- ----------------
Net cash used in investing activities (1,375,947) (827,090)
---------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividend payments (2,500) (173,602)
Net repayments under working capital loan (1,523,641)
Purchase of Treasury Stock (56,183)
Advances on notes receivable from officers (200,000)
Repayment of secured promissory notes payable and
other borrowings (37,319) (37,083)
---------------- ----------------
Net cash used in financing activities (96,002) (1,934,326)
---------------- ----------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 411,038 (316,754)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 468,271 307,666
---------------- -------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 879,309 $ 624,420
================ ================
See Notes to Condensed Consolidated Financial Statements.
4
ENVIRONMENTAL POWER CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE A -- BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of
Environmental Power Corporation ("EPC") and its subsidiaries (collectively the
"Company") have been prepared in accordance with the instructions to Form 10-Q
and do not include all of the information and footnotes required by generally
accepted accounting principles for annual financial statements. In the opinion
of management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included. The results of
operations for the three and six months ended June 30, 2002 are not necessarily
indicative of results to be expected for the year ending December 31, 2002. For
further information, refer to the consolidated financial statements and
footnotes included in the Company's Annual Report on Form 10-K for the year
ended December 31, 2001.
NOTE B -- EARNINGS PER COMMON SHARE
We compute our earnings per common share using the treasury stock method in
accordance with Statement of Financial Accounting Standard No. 128, "Earnings
per Share", or SFAS No. 128. We compute basic earnings per share by dividing net
income for the period by the weighted average number of shares of common stock
outstanding during the period. For purposes of calculating diluted earnings per
share, we consider our shares issuable in connection with stock options to be
dilutive common stock equivalents when the exercise price is less than the
average market price of our common stock for the period. We exclude antidilutive
common stock equivalents from the calculation of diluted earnings per share. The
following table outlines the calculation of basic earnings per share and diluted
earnings per share for the three and six months ended June 30, 2002 and 2001.
5
NOTE B -- EARNINGS PER COMMON SHARE (CONTINUED)
Income Shares Per Share
(Numerator) (Denominator) Amounts
----------- ----------- -----------
Three Months Ended June 30, 2002:
Loss attributable to shareholders $(1,742,507) 20,036,591 $ (.09)
Effect of dividends to preferred stockholders of subsidiary (1,250)
----------- ----------- -----------
Basic and Diluted EPS - Loss attributable to common
shareholders $(1,743,577) 20,036,591 $ (.09)
=========== =========== ===========
Three Months Ended June 30, 2001:
Loss attributable to shareholders $ (217,471) 11,406,783 $ (.02)
Effect of dividends to preferred stockholders of subsidiary (1,250)
----------- ----------- -----------
Basic and Diluted EPS - Loss attributable to common
shareholders $ (218,721) 11,406,783 $ (.02)
=========== =========== ===========
Income Shares Per Share
(Numerator) (Denominator) Amounts
----------- ----------- -----------
Six Months Ended June 30, 2002:
Income attributable to shareholders $ 24,143 20,144,423 $ .00
Effect of dividends to preferred stockholders of subsidiary (2,500)
----------- ----------- -----------
Basic EPS - Income attributable to common shareholders 21,643 20,144,423 .00
Effect of dilutive securities:
Assumed exercise of dilutive stock options 72,240
----------- ----------- -----------
Diluted EPS - Income attributable to common shareholders $ 24,643 20,216,663 $ .00
=========== =========== ===========
Six Months Ended June 30, 2001:
Income attributable to shareholders $ 770,466 11,406,783 $ .07
Effect of dividends to preferred stockholders of subsidiary (2,500)
----------- ----------- -----------
Basic EPS - Income attributable to common shareholders 767,966 11,406,783 .07
Effect of dilutive securities:
Assumed exercise of dilutive stock options 14,627
----------- ----------- -----------
Diluted EPS - Income attributable to common shareholders $ 767,966 11,421,410 $ .07
=========== =========== ===========
NOTE C -- RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board, or FASB, issued SFAS No.
141, "Business Combinations." SFAS 141 requires the purchase method of
accounting for business combinations initiated after June 30, 2001 and
eliminates the pooling of interest method of accounting. SFAS 141 also broadens
the criteria for recording intangibles separate from
6
goodwill and revises certain financial statement disclosures. The acquisition of
Microgy in 2001 was accounted for in accordance with SFAS 141.
In June 2001, The FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets." The most significant changes made by SFAS No. 142 are: 1) goodwill and
indefinite-lived intangible assets will be tested for impairment at least
annually; 2) goodwill and indefinite-lived intangible assets will no longer be
amortized to income; and 3) the amortization period of intangible assets with
finite lives will no longer be limited to forty years. SFAS No. 142 also
requires a two-phase process for impairment testing of goodwill. The first
phase, which screens for impairment, was to be completed by June 30 2002. If
necessary, we would be required to complete a second phase by December 31, 2002
to measure the impairment. Any identified impairments would be treated as a
cumulative effect of a change in accounting principle. The provisions of SFAS
142 were applied to the goodwill and intangible assets acquired in the Microgy
acquisition. We did not have acquired goodwill or intangible assets recorded on
our balance sheet prior to the Microgy acquisition. We adopted SFAS 142 on
January 1, 2002 and completed the transitional impairment testing in June 2002.
The Company assessed the implied fair value of the reporting unit by considering
a discounted cash flow analysis. Given consideration of these factors the
Company concluded that the fair value of the reporting unit exceeded the
carrying amount of its net assets and, thus, goodwill was not impaired as of
January 1, 2002.
In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement
Obligations," which is effective January 1, 2003. SFAS 143 addresses the
financial accounting and reporting for obligations and retirement costs related
to the retirement of tangible long-lived assets. We do not expect that the
adoption of SFAS 143 will have a significant impact on our consolidated
financial statements.
In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," which is effective January 1, 2002. SFAS 144
supersedes FASB Statement No 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of," and the accounting and
reporting provisions relating to the disposal of a segment of a business of
Accounting Principles Board Opinion No. 30. We adopted SFAS No. 144 on January
1, 2002 and the adoption of this principle did not have a material effect on our
consolidated financial statements.
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections."
SFAS 145 amends, among other things, the financial accounting and reporting for
extinguishment of debt obligations and certain lease modifications. The
provisions of SFAS 145 are effective for fiscal years beginning after May 15,
2002 with regard to extinguishment of debt obligations and is effective for
transactions occurring after May 15, 2002 with regard to certain lease
modifications. The remaining provisions are effective for financial statements
issued on or after May 15, 2002. We do not expect that the adoption of SFAS 145
will have a significant impact on our financial statements.
7
NOTE D - GOODWILL AND INTANGIBLE ASSETS
Intangible assets are recorded at cost and consist of licensed technology rights
and goodwill. Licensed technology rights are being amortized using the
straight-line method over a useful life of 20 years. Goodwill represents the
excess of cost over the fair value of tangible and identifiable intangible
assets and is not being amortized pursuant to SFAS No. 142 "Goodwill and Other
Intangible Assets." We did not have acquired goodwill or intangible assets
recorded on our balance sheet prior to the Microgy acquisition. Accumulated
amortization of licensed technology rights was $173,811 as of June 30, 2002 and
$81,823 as of December 31, 2001. Amortization expense for licensed technology
rights was $45,740 for the three months ended June 30, 2002, $91,988 for the six
months ended June 30, 2002 and $-0- for the three and six months ended March 31,
2001. The future estimated amortization expense for licensed technology rights
is as follows:
For the year ended December 31,
2002 $ 185,500
2003 185,500
2004 185,500
2005 185,500
2006 185,500
Thereafter 2,700,677
-----------
Total $3,628,177
===========
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Overview of the Company
We are an independent developer, owner and/or operator of electrical generating
and waste management facilities powered by non-commodity and renewable energy
fuels. Since 1994, we have owned a 22 year leasehold interest in an
approximately 83 megawatt (net) waste-coal fired facility located in
Pennsylvania known as Scrubgrass. This leasehold interest is held by our
subsidiary, Buzzard Power Corporation ("Buzzard"). Scrubgrass sells electricity
to Pennsylvania Electric Company, or Penelec, under a 25 year power sales
agreement.
In 2001, we acquired all of the common stock of Microgy Cogeneration Systems
Inc., a privately held development-stage company based in Colorado. Microgy
holds an exclusive license in North America for the development and deployment
of a proprietary technology for the extraction of methane gas from animal wastes
and its use thereof to fuel generation of energy.
8
In recent years, we have also held ownership positions in a 43 megawatt (net)
waste-coal fired project in development located in Pennsylvania, known as
Milesburg, and a 51 Megawatt (net) waste-coal fired facility located in Utah,
known as Sunnyside. Milesburg was involved in protracted litigation with, among
others, West Penn Power Company. We settled the Milesburg litigation in 1997 and
sold Milesburg to West Penn. We sold Sunnyside in 1994 and, after the sale; the
purchasers sued us claiming breach of certain obligations in connection with the
sale. We counterclaimed for payment of certain obligations of the purchasers.
The Sunnyside matters were settled in Fiscal 2001 by a payment to us of
$1,500,000 and the release of certain contingent liabilities.
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations compares the Company's results of operations for the three
and six months ended June 30, 2002 with the results of operations for the three
and six months ended June 30, 2001. Unless otherwise indicated, all references
to 2002 pertain to the six months ended June 30, 2002 and all references to 2001
pertain to the six months ended June 30, 2001. Fiscal 2002 pertains to the year
ending December 31, 2002 and Fiscal 2001 pertains to the year ended December 31,
2001. Historical results and trends which might appear should not be taken as
indicative of future operations.
Cautionary Statement
This Quarterly Report on Form 10-Q contains "forward-looking statements", as
defined by the Private Securities Litigation Reform Act of 1995, in order to
provide investors with prospective information about us. For this purpose, any
statements which are not statements of historical fact may be deemed to be
forward-looking statements. Without limiting the foregoing, the words
"believes," "anticipates," "plans," "expects," "will" and similar expressions
are intended to identify forward-looking statements. There are a number of
important factors which could cause our actual results and events to differ
materially from those indicated by the forward looking statements. These factors
include, without limitation, those set forth below under the caption "Certain
Factors That May Affect Future Results."
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements, the reported amounts of
revenues and expenses during the reporting period, and the disclosure of
contingent assets and liabilities at the date of the financial statements.
Actual results could differ from those estimates. Management believes the
following critical accounting policies, among others discussed in Note B to the
audited consolidated financial statements contained in our Annual Report on Form
10-K for the year ended December 31, 2001, involve more significant judgments
and estimates used in the preparation of our consolidated financial statements.
9
Sale and Lease-Back Accounting
Our 1990 sale of Scrubgrass Power Corporation, the original developer of the
Scrubgrass facility, was not treated as a sale for financial accounting
purposes. This was originally due to the existence of an option which enabled us
to reacquire Buzzard, then a wholly-owned subsidiary of Scrubgrass Power
Corporation and owner of the right to lease the Scrubgrass facility, for a
substantial portion of its commercial operation. We exercised our option and
reacquired Buzzard in 1991 so that we would have the right to lease the
Scrubgrass facility. The then-proposed lease provided Buzzard with a fair market
value purchase option to acquire the Scrubgrass facility at the end of the
lease. This option meant that we had retained substantial risks or rewards of
ownership of Scrubgrass. Therefore, we were not permitted to recognize the sale
until 1993, when we agreed to a modification to the proposed form of lease and
relinquished the fair market value purchase option. Accordingly, we removed from
our consolidated financial statements the gross assets and liabilities of the
Scrubgrass facility and reported a gain of $6,785,035 arising from the sale of
Scrubgrass. However, due to our anticipated involvement with the lease, we were
required to defer our gain over the 22 year minimum lease term, which commenced
on June 30, 1994. In connection with the operating lease, we incurred aggregate
costs of $3,279,060 to reacquire Buzzard, the lessee of Scrubgrass, and
capitalized these costs as the value of our lease rights. The value of our lease
rights is also being amortized over the 22 year minimum lease term, which
commenced on June 30, 1994.
Lease Expense Recognition
We have a long-term lease agreement for Scrubgrass, which commenced on June 30,
1994, and continues for a 22 year minimum lease term. Under the terms of the
lease, Buzzard, as lessee, is required to pay the lessor a specified base rent,
which consists of all of the lessor's debt service, scheduled equity repayment,
base return on equity and related expenses. Buzzard is also required to pay the
lessor an additional rent of 50 percent of the net cash flows Buzzard receives
from the operation of Scrubgrass. The lessor's specified base rent increases
over time and is based on a schedule which follows the expected receipt of
revenues. In accordance with accounting principles generally accepted in the
United States of America, we are required to aggregate the estimated lease
payments over the life of the lease and recognize them on a straight-line basis
over the 22-year lease term. As such, during the earlier years of the lease
agreement, a portion of our lease expenses will be paid in cash and a portion
will be recorded to a liability. As of June 30, 2002, we have an accrued lease
expense of $66,920,989 recorded on our consolidated balance sheet. This
liability represents accumulated lease expenses recorded on a straight-line
basis in previous years which have not been paid to the lessor. In the later
years of the lease, we expect that our cash payments to the lessor will exceed
the lease expenses recorded on a straight-line basis and the accrued lease
expense will be decreased and reach zero by the end of the lease term. This
straight-line accounting treatment of certain lease expenses under the
Scrubgrass lease resulted in non-cash lease expense of $1,636,002 and $3,271,994
for the three and six months ended June 30, 2002, respectively, as compared to
$1,865,214 and $3,730,422 for the three and six months ended June 30, 2001,
respectively. Environmental Power, which owns 100% of Buzzard's common stock, is
not liable for future lease rental payments. The stock of Buzzard is pledged as
security and Buzzard is only liable for future lease rental payments to the
extent Buzzard receives cash receipts from future power generation revenues.
10
Our lease expense components, which are discussed in the following paragraphs,
consist of:
o specified base rent payments calculated on a straight-line basis;
o additional rent; and
o current period adjustments resulting from differences between actual
lease billings and projected lease billings. This accounting is
mandated to conform to accounting principles generally accepted in the
United States of America.
As noted above, Buzzard, as lessee, is required to pay the lessor a specified
base rent, which consists of all of the lessor's debt service, scheduled equity
repayment, base return on equity and related expenses. The lessor's debt service
largely consists of debt obligations with variable interest rates. Therefore, in
order to calculate future minimum lease payments, we estimate an average
interest rate which will be payable in the future for each variable rate debt
obligation. Since actual interest rates will differ from these estimates, our
actual lease expense reported in future periods will differ from these estimates
and the differences may be material.
In order to calculate the straight-line lease expense, we take the total
estimated future minimum lease payments over the lease term and divide it by the
lease term to get an annual lease expense. The annual lease expense is then
compared to the total amount projected to be billed by the lessor in each
period, and the difference is reported as a straight-line lease expense in our
consolidated financial statements. Any differences between actual lease billings
and projected lease billings, which principally result from variances between
actual interest rates and projected interest rates, are reported as a lease
expense in the current period.
We are also required to pay the lessor an additional rent, in addition to the
specified base rent, which additional rent represents 50 percent of the net cash
flows Buzzard receives from the operation of Scrubgrass. We estimate and accrue
additional rent in the accounting period when we believe the cash flows were
generated from operations. However, because additional rent is based on cash
flows and not earnings, it is more subjective to determine when the cash flows
were generated from operations. Lease expenses may also cause large fluctuations
between accounting periods in our reported earnings since the specified base
rent and additional rent are not directly related to our earnings. Additional
rent is not part of the straight-line lease expense calculation.
Revenue Recognition
We record power generation revenues when electricity is transmitted to the
utility under the terms of the underlying power sales agreement. However, under
the terms of our long-term power sales agreement, or PPA, with Penelec, the same
annual generation of electricity is expected to result in significant increases
in revenues over the life of this agreement. For various reasons, including the
requirement that all the power generated by the Scrubgrass facility be sold to
one customer, we account for power generation revenues under the lease
accounting rules as if the power sales agreement was a sublease to this
customer. In accordance with accounting principles generally accepted in the
United States of America, we are therefore required to
11
aggregate the expected revenue to be received over the life of the power sales
agreement and recognize it on a straight-line basis over the 22-year lease term.
As such, during the early years of the power sales agreement with Penelec, a
portion of our power generation revenues will be received in cash and a portion
will be recorded to an asset. However, since we cannot predict whether revenues
would be collected over the entire life of the power sales agreement, and absent
revenues, whether Buzzard would be able to perform under the lease, the
recognition of revenue on a straight-line basis was limited to the recognition
of lease expense on a straight-line basis. As a result, net income is not
affected by straight-line lease and revenue accounting and our financial
statements are presented more conservatively. As of June 30, 2002, we have
accrued power generation revenue of $66,920,989 recorded on our consolidated
balance sheet which is equal in amount to the accrued lease expense. This asset
represents accumulated revenue recorded on a straight-line basis in previous
years which has not been collected from Penelec. This straight-line accounting
treatment of power generation revenue under the power sales agreement with
Penelec, resulted in non-cash revenues of $1,636,002 and $3,271,994 for the
three and six months ended June 30, 2002, respectively, as compared to
$1,865,214 and $3,730,422 for the three and six months ended June 30, 2001,
respectively. In the later years of the power sales agreement, when power rates
are expected to increase we expect that our cash receipts from Penelec will
exceed the revenues recorded on a straight-line basis and the accrued power
generation revenue will be decreased and reach zero by the end of the lease
term. Future cash collections from power generation revenue may vary from the
projections used to aggregate the expected revenue to be received over the life
of the power sales agreement, which we recognize on a straight-line basis over
the 22-year lease term.
12
Accounting for Income Taxes
As part of the process of preparing our consolidated financial statements we are
required to estimate our income taxes in each of the jurisdictions in which we
operate. This process involves us estimating our actual current tax exposure
together with assessing temporary differences resulting from differing treatment
of items, such as our deferred gain and lease rights, for tax and accounting
purposes. These differences result in deferred tax assets and liabilities, which
are included within our consolidated balance sheet. We must then assess the
likelihood that our deferred tax assets will be recovered from future taxable
income and to the extent we believe that recovery is not likely, we must
establish a valuation allowance. To the extent we establish a valuation
allowance or increase this allowance in a period, we must include an expense
within the tax provision in the statement of operations.
Significant management judgment is required in determining our provision for
income taxes, our deferred tax assets and liabilities and any valuation
allowance recorded against our deferred tax assets. As of June 30, 2002, we have
recorded a net deferred income tax liability of $228,115 on our consolidated
balance sheet. We have also recorded a valuation allowance of $148,377 against
our gross deferred income tax assets as of June 30, 2002, due to uncertainties
related to our ability to utilize some of our net operating loss carry forwards
before they expire. The valuation allowance is based on our estimates of taxable
income by jurisdiction in which we operate and the period over which our
deferred tax assets will be recoverable. In the event that actual results differ
from these estimates or we adjust these estimates in future periods we may need
to establish an additional valuation allowance which could materially impact our
financial position and results of operations.
Intangible Assets
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 141, "Business Combinations" and SFAS No.
142, "Goodwill and Other Intangible Assets". SFAS No. 141 requires the purchase
method of accounting for all business combinations and that certain acquired
intangible assets in a business combination be recognized as assets separate
from goodwill. SFAS No. 142 requires that goodwill and other intangibles
determined to have an indefinite life are no longer to be amortized but are to
be tested for impairment at least annually. We have applied SFAS No. 141 in our
accounting for the acquisition of Microgy. Accordingly, we identified and
allocated a value of $3,710,000 to Microgy's licensed technology rights and a
value of $4,912,866 to goodwill. The valuation of these intangible assets
required us to use significant judgment. On January 1, 2002, we adopted SFAS No.
142, which required us to perform an initial impairment test during 2002 on our
acquired intangible assets and goodwill. The Company determined the implied fair
value of its reporting unit using a discounted cash flow analysis and compared
such value to the reporting unit's carrying amount. This evaluation, completed
in June of 2002, indicated that the goodwill in the Microgy reporting unit was
not impaired as of January 1, 2002.
Results of Operations
Net income for the six months ended June 30, 2002 amounted to $24,143, or 0.0
cents per share; as compared to net income $770,466, or 7 cents per share; for
the six months ended June 30, 2001.
13
The decrease in net results during the six months ended June 30, 2002 is
primarily attributable to an increase in the following:
o operating expenses;
o lease expenses; and
o general expenses.
The effect of these changes was offset in part by an increase in:
o power generation revenues;
o other income; and
o a decrease in income tax expense.
Net loss for the three months ended June 30, 2002 amounted to $1,742,507, or 9
cents per share; as compared to a net loss of $217,471, or 2 cents per share;
for the three months ended June 30, 2001. The decrease in net results during
the three months ended June 30, 2002 is primarily attributable to:
o a decrease in power generation revenues;
o an increase in lease and general and administrative expenses; and
o decreased other income.
The effect of these changes was offset in part by a decrease in:
o operating expenses; and
o an increase in the income tax benefit.
The reasons for these changes in our net results are discussed in more detail in
the following sections.
Power generation revenues for the six months ended June 30, 2002 amounted to
$26,090,461, as compared to $25,579,769 for the same period in 2001. The
increase in power generation revenues during the six months ended June 30, 2002
is primarily attributable to a 5% increase in certain rates billed to Penelec
under the terms of the PPA.
This increase was offset in part by a decrease:
o in the revenue recorded as a result of the straight-line accounting
treatment of certain revenues under the PPA which amounted to
$3,271,994 and $3,730,422 for the six months ended June 30, 2002 and
2001, respectively; and
o the Scrubgrass Project, which operated at 86.2% of its capacity for
the six months ended June 30, 2002 as compared to 86.9% for the same
period in 2001, had a slight decrease in power generation during each
six month period.
14
Power generation revenues for the three months ended June 30, 2002 amounted to
$11,977,206 as compared to $12,096,878 for the same period in 2001. The decrease
in power generation revenues during the three months ended June 30, 2002 is
primarily attributable to:
o a decrease in the non cash revenue recorded as a result of the
straight-line accounting treatment of certain revenues under the PPA
which amounted to $1,636,002 and $1,865,214 for the three months ended
June 30, 2002 and 2001, respectively.
This decrease was partially offset by an increase in actual revenue billed to
Penelec which amounted to $10,341,203 and $10,231,588 for the three months ended
June 30, 2002 and 2001, respectively.
o the Scrubgrass project had its planned annual maintenance outages
during the second quarters in both 2002 and 2001. During each of the
2002 and 2001 planned annual maintenance outages, the Scrubgrass plant
was inoperative for approximately two and one half weeks, to perform
scheduled maintenance procedures; and
o the Scrubgrass Project incurred unscheduled shutdowns to respond to
equipment malfunctions and problems with the fuel having high moisture
content during the second quarter of 2002.
Operating expenses for the six months ended June 30, 2002 amounted to
$12,614,544, as compared to $12,487,073 for the same period in 2001. The
increase in operating expenses during the six months ended June 30, 2002 is
primarily attributable to higher fuel costs primarily from cost escalations in
certain fuel supply agreements, changes in fuel mix and quality;
Operating expenses for the three months ended June 30, 2002 amounted to
$7,469,811 as compared to $7,529,833 for the same period in 2001. The decrease
in operating expenses during the three months ended June 30, 2002 is primarily
attributable to a bag house air pollution control system replacement in 2001
that did not occur in 2002 and a decrease in benefit rates charged by the plant
manager. These decreases were partially offset by increases in fuel costs due to
contract escalation and the cost of replacing an economizer unit.
Lease expenses for the three and six months ended June 30, 2002 amounted to
$6,291,677 and $13,075,057, respectively, as compared to $5,859,101 and
$11,874,123 for the three and six months ended June 30, 2001, respectively. The
increase in lease expenses during the three and six months ended June 30, 2002
is primarily attributable to the following reasons:
o we incurred scheduled increases in base equity rents paid to the
lessor; and
o the additional rents paid to the lessor, which amount to 50 percent of
the net cash flows from the Scrubgrass Project, amounted to $1,412,946
and $3,294,824 for the three and six months ended June 30, 2002,
respectively, as compared to $391,657 and $591,656 for the three and
six months ended June 30, 2001, respectively.
15
This overall increase in lease expenses was offset in part by the following
decreases in certain other lease expenses during the three and six months ended
June 30, 2002:
o we had a decrease in lease expenses recorded as a result of the
straight-line accounting treatment of certain lease expenses under the
Scrubgrass lease which amounted to $1,636,002 and $3,271,994 for the
three and six months ended June 30, 2002, respectively, as compared to
$1,865,214 and $3,730,422 for the three and six months ended June 30,
2001, respectively; and
o the lessor's loan costs, which are passed along to the Company as a
lease expense, decreased due to reductions in the following two items:
o average variable interest rates; and
o outstanding principal balances on term loans.
General and administrative expenses for the three and six months ended June 30,
2002 amounted to $976,662 and $2,334,541, respectively, as compared to $802,751
and $1,488,480 for the three and six months ended June 30, 2001, respectively.
The increases in general and administrative expenses during the three and six
months ended June 30, 2002 was primarily attributable to increases in most
categories as a result of the continued development of efforts to implement the
Microgy business plan. These increases were offset in part by decreases in
Scrubgrass expenses during the three and six months ended June 30, 2002.
Other income and expense for the three and six months ended June 30, 2002
amounted to $50,378 and $2,536,735, respectively, as compared to $1,744,900 and
$1,771,484 for the three and six months ended June 30, 2001, respectively. The
other income for the six months ended June 30, 2002 was primarily the result of
the sale of NOx emission credits for $2,428,200 during the first quarter of
2002. The other income for the three months ended June 30, 2001 was primarily a
result of:
o the settlement proceeds of $1,500,000 in the second quarter of 2001;
and
o contingent liability release of $177,962 related to the Sunnyside
Project as other income during the second quarter of 2001.
Income tax expense amounted to $306,251 and $558,000 for the six months ended
June 30, 2002 and 2001, respectively, and income tax benefit amounted to
$1,104,749 and $219,000 for the three months ended June 30, 2002 and 2001,
respectively. The decrease in income tax expense for the six months ended June
30, 2002 is primarily attributable to a decrease in earnings before taxes. The
increase in income tax benefit for the three months ended June 30, 2002 is
primarily attributable to an increase in loss before taxes.
The effective income tax rate for the year ended December 31, 2002 ("Fiscal
2002") is currently projected to be approximately 92%, which is higher than the
actual tax rate of approximately 45% incurred during the year ended December 31,
2001 ("Fiscal 2002"). Our taxable earnings are significantly concentrated in
Pennsylvania during Fiscal 2002, which state carries the highest effective tax
rate for the Company. Since we do not consolidate earnings for Pennsylvania
state tax purposes, the expenses being incurred to execute the Microgy plan are
not deductible in Pennsylvania.
16
Segment Information - When comparing our results for the six month period ended
June 30, 2002 to the comparable period in 2001 it is important to note that
Microgy Cogeneration Systems was not part of our results in 2001. We currently
have two business segments that are at very different stages of their business
cycle.
As previously mentioned, we have owned a 22 year leasehold interest, since 1994
in an approximately 83 megawatt (net) waste-coal fired facility located in
Pennsylvania known as Scrubgrass. Scrubgrass is a mature business that has
generally operated profitably with positive cash flow. Scrubgrass sells
electricity to Pennsylvania Electric Company, or Penelec, under a 25 year power
sales agreement. Scrubgrass generated revenues of $26,090,461 for the six months
ended June 30, 2002 as compared to $25,579,769 for the comparable period in
2001. Scrubgrass net income before consolidation was $1,137,708 for the six
month period ended June 30, 2002 as compared to $110,392 for the comparable
period in 2001. Additionally, Scrubgrass provided gross cash flows to us of
$3,776,536 for the six month period ending June 30, 2002 as compared to $610,232
for the comparable period in 2001.
To properly evaluate the improvement in Scrubgrass net income and cash flow for
the six month period ending June 30, 2002 it is important to note an unusual
item in 2002. During the first quarter of 2002 we sold $2,428,200 of NOx
emission credits; in 2001 there were no sales of NOx emission credits.
Also, EPC in the second quarter of 2001 recognized $1,677,962 as other income
that was comprised of proceeds of litigation of $1,500,000 and contingent
liability release of $177,962 related to the Sunnyside Project. There was no
comparable event in 2002.
Our newest business segment, Microgy Cogeneration Systems is a development stage
business, which we expect to build and operate systems that provide waste
management and power generation at confined animal operations. As such, it
requires EPC to make cash investments in the development and expansion of the
business. In the first six months of 2002, our general and administrative
expenses for the combination of our corporate overhead and Microgy expansion
costs were $1,718,505 as compared to $707,877 for the comparable period in 2001.
The 2001 period did not include Microgy costs.
This larger level of spending in the 2002 is one of the major reasons why our
net income for the three and six month periods ending June 30, 2002 is lower on
a consolidated basis as compared to the same period in 2001.
2002 Outlook
The following forward-looking information concerning our results of operations
for Fiscal 2002 is being compared to our historical results of operations for
Fiscal 2001:
Power generation revenues are expected to increase in Fiscal 2002 primarily due
to a 5% increase in rates billed to Penelec under the Scrubgrass power sales
agreement. This increase is expected to be
17
partially offset by a decrease in revenue recorded as a result of the
straight-line accounting treatment of revenue under the power sales agreement.
Operating expenses are expected to increase in Fiscal 2002 primarily due to:
o an escalation in rates for fuel supply agreements;
o changes in the scope of planned maintenance procedures and facility
modifications; and
o a 5% escalation in operator fees under the terms of the operations and
maintenance agreement
Lease expenses are expected to increase in Fiscal 2002 primarily because:
o we have scheduled increases in base equity rent payments; and
o we expect additional rents paid to the lessor, which amount to 50
percent of the net cash flows from Scrubgrass, will increase due to
projected increases in cash flows from Scrubgrass operations.
However, these increases may be partially offset because:
o we expect the lessor to bill us lower scheduled term loan principal
payments pursuant to the terms of the lease;
o we expect to have a decrease in the lease expense recorded as a result
of the straight-line accounting treatment of lease expenses under the
lease agreement; and
o we expect lower outstanding balances for term loans to lessen the
lessor's interest costs that would be billed to us under the terms of
the lease.
General and administrative expenses are expected to increase during Fiscal 2002
primarily because:
o we have made and expect to make changes in our work force to seek to
develop and accomplish our Microgy business plan;
o we continue to employ consultants for technical, financial, legal,
marketing, public and investor relations and other strategic advice;
o Microgy corporate overhead would be included in our results of
operations for all of Fiscal 2002 versus approximately five months in
Fiscal 2001; and
o we expect numerous corporate expenses like insurance, office supplies,
rent, legal, and travel to increase due to business expansion efforts.
Other income is expected to increase slightly in Fiscal 2002. During Fiscal
2002, we expect to report sales of NOx emission credits of approximately $2.4
million. In Fiscal 2001, we had other income of approximately $2.1 million from
the settlement of the Sunnyside litigation.
Excluding the effect of any share issuances or repurchases during Fiscal 2002,
our weighted average common shares outstanding would have increased from
14,144,222 shares in Fiscal 2001 to 20,251,653 shares in Fiscal 2002. We
expected this increase because our shares issued for the acquisition of Microgy,
which were weighted from the respective dates they were issued in Fiscal
18
2001, were expected to be outstanding for all of Fiscal 2002. This increase is
expected to significantly dilute our basic and diluted earnings per common share
during Fiscal 2002. However, as discussed in Part II - Item 5, we have
repurchased, and expect to repurchase in the future, shares during Fiscal 2002
from Benjamin Brant, a director of EPC and former officer of Microgy. Absent new
issuances, the share repurchases from Mr. Brant would be expected to reduce our
weighted average common shares outstanding in Fiscal 2002 to below the
20,251,653 shares outstanding as of the beginning of Fiscal 2002.
Recently Issued Accounting Standards
There are five recently issued accounting standards which are described in Note
C to the Condensed Consolidated Financial Statements.
Liquidity and Capital Resources
Operating Activities
We had cash provided by operating activities of $1,882,987 and $3,078,170 during
the six months ended June 30, 2002 and 2001, respectively. During these periods,
our only sources of cash from operating activities were operating profits from
the Scrubgrass Project, proceeds from the settlement of the Sunnyside
litigation, proceeds from sales of NOx Credits and investment earnings.
Our net income during the six months ended June 30, 2002 and 2001 contributed a
portion of the cash provided by operations. The following adjustments, which did
not impact our cash flows, need to be considered in order to reconcile our net
income during the six months ended June 30, 2002 to our net cash provided by
operating activities:
o Depreciation and amortization - During the six months ended June 30,
2002, we recognized depreciation and amortization for lease rights of
$74,502, deferred financing costs of $31,127, machinery and equipment
modifications and equipment and furniture of $75,043.
o Deferred gain, net - Our deferred gain, net, amounted to $4,317,750 as
of June 30, 2002 as compared to $4,471,955 as of December 31, 2001.
The decline is due to the amortization of the deferred gain related to
the Scrubgrass Project, which is being amortized on a straight-line
basis over 22 years.
We also offer the following information to discuss changes in our operating
assets and liabilities which most notably impacted our cash position during the
six months ended June 30, 2002:
o Receivable from utility - Our receivable from utility relates to the
Scrubgrass Project and amounted to $5,978,823 as of June 30, 2002 as
compared to $7,905,864 as of December 31, 2001. The decrease in the
receivable from utility as of June 30, 2002 is primarily attributable
to the scheduled annual outage during the second quarter of 2001,
which reduced power generation revenues during this quarter by
comparison to the fourth quarter
19
of 2001. This decrease was offset in part by a 5% increase during 2002
of certain contracted rates under the PPA. Power generation revenues
are discussed further under "Results of Operations".
o Other current assets - Our other current assets amounted to $912,946
as of June 30, 2002 as compared to $607,590 as of December 31, 2001.
The increase in other current assets is primarily attributable to
higher on-hand quantities of fuel inventory and a seasonal increase in
prepaid insurance.
Accounts payable and accrued expenses - Our accounts payable and accrued
expenses amounted to $8,276,399 as of June 30, 2002 as compared to $9,382,471 as
of December 31, 2001. The decrease in accounts payable and accrued expenses is
primarily attributable to the following reasons:
o accrued bond interest due to the lessor decreased largely due to lower
average interest rates;
o accrued lease expenses as of December 31, 2001 included higher
scheduled principal payments on the lessor's terms loans;
o certain costs which are paid annually during the first quarter and
accrued monthly during the calendar year had only six months of
expense accrual as of June 30, 2002 versus 12 months of expense
accrual as of December 31, 2001; and
o corporate taxes payable decreased from $1,157,066 as of December 31,
2001 to $234,363 as of June 30, 2002.
The aforementioned decreases were offset in part by the following increase in
accounts payable and accrued expenses:
o due to our annual maintenance outage, we incur seasonal increases in
operating expenses during the second quarter of each year; and
o as discussed under Results of Operations, we had other increases in
certain operating expenses during 2002 which led to increases in
accounts payable and accrued expenses as of June 30, 2002.
Investing Activities
We used $1,375,947 and $827,090 in investing activities during the six months
ended June 30, 2002 and 2001, respectively. Our investing activities are
concentrated primarily in the following areas:
o Restricted cash - We are presently required to make scheduled deposits
to a restricted major maintenance fund relating to the Scrubgrass
Project to ensure that funds are available in the future for scheduled
major equipment overhauls. We are also allowed to spend restricted
cash to fund the cost of major equipment overhauls subject to certain
restrictions. During the six months ended June 30, 2002 and 2001, the
balance of the restricted major maintenance fund was increased by
scheduled deposits and interest earnings on the deposit of $630,748
and $623,677, respectively. Expenditures for major equipment overhauls
during the six months ended June 30, 2002 were $57,050; we did not
make
20
expenditures for major equipment overhauls during the six months ended
June 30, 2001. Major equipment overhauls are subject to certification
by an independent engineer and are performed on a pre-established
schedule which can differ widely from year to year. The selection of
equipment for service and/or replacement each year depends on factors
such as the condition of the equipment, expected wear and tear, and
recommendations made by equipment manufacturers. Beginning in February
2002, we are required to make deposits to the restricted major
maintenance fund of $92,331 per month through April 2005. The required
monthly payment is subject to possible recalculation after each annual
maintenance outage to ensure that funds are sufficient to cover the
long-term schedule of major equipment overhauls.
o Property, plant and equipment - We made property, plant and equipment
expenditures of $393,968 and $1,000 during the six months ended June
30, 2002 and 2001, respectively. The 2002 purchases have been
comprised of $41,602 for office equipment at our corporate
headquarters and $349,045 for systems installed at our Scrubgrass
Plant.
o Project development activities - We expect to begin the sale and/or
development and construction of facilities using Microgy's licensed
technology during 2002. To the extent we are the owner of these
facilities, we will require financing to complete the development and
construction of the facilities which is discussed under financing
activities. During the three month period ended June 30, 2002, we
capitalized $408,302 of project development costs. There were no
project development costs capitalized during the first quarter of 2002
or in 2001. Project development cost are capitalized once the
likelihood of their recovery (for example, through future project's
operating earnings or through other reimbursement) is considered
probable by management.
Financing Activities
The Company used $96,002 and $1,934,326 in financing activities during the six
months ended June 30, 2002 and 2001, respectively. The Company's financing
activities are concentrated primarily in the following areas:
o Related Party Loan - On September 14, 2001, we borrowed $750,000 from
Alco Financial Services LLC, or Alco, to fund certain expenses related
to the acquisition of Microgy and provide additional working capital
for our expansion efforts. Robert Weisberg, one of our directors, is
the President, Director and a member of Alco. The loan is evidenced by
a one-year promissory note which bears interest at the prime rate plus
3.5%. We also pay an administrative fee of 0.6% per month. The loan is
secured by all of EPC's assets, except for the common stock of
Buzzard, which is already pledged to the lessor of Scrubgrass. In
connection with the loan, we granted Alco five year warrants to
purchase 50,000 shares of common stock at $0.60 per share. In April
2002, the principal repayment terms of the loan were modified so that
all principal is now due by April 1, 2003.
o Dividends - Since March 2001, the Board of Directors has not declared
any dividends on our common stock. Due to the recent acquisition of
Microgy and anticipated expansion
21
of our business, the Board of Directors has concluded that available
cash flows should be used for operating and investing activities for
the foreseeable future. We paid dividends to a preferred stockholder
of Buzzard of $2,500 during each of 2002 and 2001. We also had
dividends payable of $171,102 as of December 31, 2000, which were
declared during the fourth quarter of 2000 and paid on January 10,
2001. As such, we paid aggregate dividends of $2,500 in 2002 and
$173,602 in 2001.
o Working Capital Loan - Buzzard may borrow up to $4 million under a
Lessee Working Capital Loan Agreement with the lessor of Scrubgrass
for ongoing working capital requirements of this project. The
outstanding borrowings under this loan were $2,318,048 as of June 30,
2002 and $1,116,905 as of December 31, 2001. As discussed below, the
Lessee Working Capital Loan Agreement expires in December 2002 and is
in the process of being refinanced. Under the existing terms of this
loan, we were required to pay the outstanding balance to zero for a
minimum of twenty days during 2001 and 2002. We have already met the
pay down requirement for this loan during 2002.
o Refinancing at Scrubgrass - PG&E National Energy Company, NEG the
manager of Scrubgrass, continues to be in long-term refinancing
discussions with the lending agent for the project. NEG is addressing
the financing matter regarding Buzzard's expected requirement for
additional working capital beginning in August 2003, when Penelec's
contracted payment terms will be extended by 20 days.
NEG has extended the existing Working Capital Loan until December 2006. The
terms and conditions of the loan remain the same. NEG is in discussions with
Penelec with a proposal to pay Penelec a monthly fee for keeping the contractual
payment terms the same rather than extending them by 20 days. Penelec has given
an initial indication that they are willing to make this change to the existing
contract terms. Should there be delays in finalizing this agreement, our
distributions from Scrubgrass may be delayed or reduced. As time passes, there
can also be no assurance that the terms of the provisional agreement would not
be amended to reflect changes in market conditions.
Scrubgrass Debt Obligations
Buzzard and the lessor have various debt obligations related to Scrubgrass.
Under the terms of the Scrubgrass lease, Buzzard is required to pay the
principal, interest and fees for the lessor's debt obligations as a base lease
payment. As such, Buzzard is committed to pay all of the Scrubgrass debt
obligations as either a debt or lease obligation. Scrubgrass had the following
debt obligations as of June 30, 2002 and December 31, 2001:
22
Balance at Balance at Matures
Description of the Obligation 6/30/02 12/31/01 Interest Rate Through
- ----------------------------- ------- -------- ------------- -------
Buzzard's lease obligations:
Variable rate tax-exempt
bonds $135,600,000 $135,600,000 Quoted Bond Rates 2012
Swap rate term loan 9,690,415 10,669,663 7.6725% 2005
Variable rate term loan 8,028,572 8,344,479 LIBOR + 1.250% 2004
Buzzard's debt obligations:
Variable rate term loan 948,428 985,437 LIBOR + 1.250% 2004
Working capital loan 2,318,048 1,116,905 LIBOR + 1.250% 2002
Buzzard's lease obligations for the lessor's debt are not reported in our
consolidated financial statements. As these debt obligations mature, they will
be billed by the lessor to Buzzard and reported as a lease expense in our
consolidated financial statements. Buzzard made principal repayments on its
variable rate term loan of $37,319 in 2002 and $37,083 in 2001.
Notes Receivable from Officers and Board Members - We have outstanding notes
receivable from officers and board members for shares purchased in connection
with stock option plans which amounted to $645,948 as of June 30, 2002 and
December 31, 2001. These notes, which are secured by the underlying shares of
stock, are payable upon demand and bear interest at a floating rate which is
payable monthly. There were no borrowings or repayments under these outstanding
notes receivable during 2002 and 2001.
Sunnyside Contingent Obligations
We had contingent obligations of $1,218,078 on our consolidated balance sheet as
of December 31, 2000. The contingent obligations were principally expenses for
the sale of Sunnyside which were payable upon collection of certain obligations
from the purchasers of Sunnyside. On April 10, 2001, we received aggregate
proceeds of $1,500,000 from the purchasers of Sunnyside and resolved litigation
by executing a Binding Settlement Agreement. In this agreement, we were formally
released from contingent obligations of $177,962. We have also been released by
the statute of limitations or the terms of the underlying agreements from
additional contingent obligations of $457,086. We reported the settlement
proceeds of $1,500,000 and the released liabilities of $635,048 as other income
in our consolidated financial statements for Fiscal 2001.
Because of the terms of this settlement agreement, which terms represented a
substantial compromise of our previous claims against the purchasers of
Sunnyside, we are presently considering our rights and obligations with respect
to the remaining contingent obligations of $583,030. Until we resolve these
remaining issues, the unsettled contingent obligations will remain recorded in
secured promissory notes and other borrowings in our consolidated financial
statements.
Cash Flow Outlook
During Fiscal 2002, we have to date and expect to principally fund our business
activities from available cash balances, investment earnings, proceeds from
sales of NOx Credits, additional cash which may become available from Scrubgrass
and any equity and/or debt financing we obtain. We are not able to receive
distributions from Scrubgrass until all operating expenses, base lease
23
payments, restricted cash deposits and other subordinated payments of Scrubgrass
are satisfied. Nevertheless, Scrubgrass cash flows in Fiscal 2002 are expected
to be sufficient to satisfy all of these restrictions and provide us with
continuing distributions for the foreseeable future.
On June 30, 2002, our unrestricted cash balance increased to $879,309 from
$468,271 as of December 31, 2001. On June 30, 2002, our restricted cash balance
increased to $1,588,257 from $1,014,580 as of December 31, 2001. As discussed
further under investing activities, we are allowed to spend restricted cash to
fund the cost of major equipment overhauls at Scrubgrass subject to certain
restrictions.
As of June 30, 2002, we have received year-to-date distributions from Scrubgrass
of $3,776,536 compared to distributions of $610,231 for the same period in 2001.
Scrubgrass has been operating favorably with annual capacity rates in excess of
90% for the last two years. Since Scrubgrass is so highly leveraged with
variable rate debt, the recent trend of low interest rates and favorable
operations has allowed Scrubgrass to generate unprecedented cash flows from its
operations. Assuming the continuing trends of favorable operations and low
interest rates, we expect to receive record levels of distributions from
Scrubgrass in Fiscal 2002. Therefore, for the next twelve months, we expect that
distributions from Scrubgrass combined with our current cash balances will
likely be sufficient to fund:
o EPC's corporate overhead requirements; and
o repayment of the Alco loan to the extent the loan is not refinanced or
replaced.
In order to continue development of Microgy as planned and provide additional
working capital in the event Scrubgrass distributions are less than anticipated,
or corporate overhead expenses are greater than anticipated, we are engaging in
discussions with various potential sources of debt or equity funding. We may
also need to expand our business more rapidly than expected, including our staff
and internal systems, if market responses to our Microgy products are greater
than our current expectations or we encounter greater obstacles in expanding
Microgy. Therefore, we believe it is necessary to explore these possibilities
for additional financing. There can be no assurance that such additional
financing would be obtained or, if obtained, will be on terms acceptable to us.
During Fiscal 2002, Microgy has commenced the sale and development process and
expects to begin construction of projects based upon the anaerobic digestion
technology licensed to us. Our present business strategy generally anticipates
the outright sale of facilities; however, in some circumstances, we expect that
Microgy may own some or even a majority of the projects. We anticipate that, to
the extent Microgy is the owner of projects, project financing may be obtained
in the form of a credit facility with one or more lenders, the sale of tax
exempt or taxable bonds to investors or equity or other financing. Microgy can
offer no assurance that it will be able to secure project financing in the
amount required to fulfill any development or construction requirements, that
project financing will be obtained in time to meet such requirements, or that
any such proposed project financing, if obtained, will be on terms acceptable to
Microgy. However, to the extent Microgy is the owner of projects, Microgy will
need to obtain financing to allow it to develop and construct such projects.
24
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
The following important factors, among others, could cause actual results to
differ materially from those indicated by forward-looking statements made in
this Quarterly Report on Form 10-Q.
Microgy, a company that we recently acquired, has very little operating history
from which to evaluate its business and products.
Microgy was formed in 1999 and is still in the development stage. Microgy
intends to develop facilities which use environmentally friendly anaerobic
digestion and other technologies to produce bio-energy from animal and organic
wastes. Because a large part of our future business is anticipated to involve
Microgy's bio-energy projects and Microgy is an enterprise with very little
operating history upon which to judge, we are unable to determine whether our
investment in Microgy will prove to be profitable.
Microgy has experienced losses to date and we anticipate it will continue to
experience losses in the foreseeable future.
Microgy had accumulated losses due primarily to expenses of business
development of approximately $2,772,766 through June 30, 2002. We expect our
Microgy subsidiary to continue to incur losses, reduce our earnings or, as the
case may be, add to our earnings deficit as we seek to further develop its
business. These ongoing losses will likely adversely affect our financial
condition into the foreseeable future.
We have not completed our plans for deployment of our anaerobic digester
technology and therefore, cannot predict its related costs or outlook for
profitability.
The strategic implementation planning necessary to determine our course of
action for deployment of our anaerobic digester technology has not been
completed. The decision as to whether we will sell, install and operate, or
develop and own the related facilities, is expected to be made on a case by case
basis. In addition, we do not have experience in, or a basis for, predicting the
general and administrative and other costs associated with developing anaerobic
digester facilities. Because of this we are unable to determine when or if these
facilities will generate a profit. If the organizational, structural, staffing
and other overhead costs associated with the anaerobic digester facilities
outstrip any profits, the value of your investment will be adversely affected.
If we are unable to obtain needed financing for Microgy's anaerobic digestion
bioenergy projects, the valuation of our Microgy investment may be reduced
significantly.
We are considering corporate, project and group financing to fund the cost
of any development we may decide to pursue for our anaerobic digestion bioenergy
projects. In such event, we are likely to require financing and such financing
may be difficult to obtain. If we are unable to obtain such financing, our
initial valuation of our Microgy investment may be reduced
25
significantly, and we may be required to substantially curtail our business or
close any anaerobic digester projects. This financing will depend on the
lender's or investor's review of the financial capabilities of us as well as
specific project or projects and other factors, including their assessment of
our ability to successfully construct and manage the project.
Microgy's technologies could become obsolete before commercial deployment,
reducing the value of your investment.
We do not expect to commercially deploy Microgy's licensed anaerobic
digestion bioenergy technologies until we further develop Microgy's business
plan, decide on project structures and arrange necessary financing. Current
solutions or solutions that may be developed in the future by competitors could
make our anaerobic digestion bioenergy technologies obsolete before they are
commercially deployed. Accordingly, we cannot guarantee that our technologies
will ensure a competitive position within the marketplace in the future. If we
are unable to obtain a competitive position in the agricultural and alternative
power generation markets, the value of your investment will be reduced.
If we experience delays in obtaining the technical information and specifics
needed to build our licensed anaerobic digester technologies, our business could
be harmed and the value of your investment could be reduced.
The company from which we license intellectual property regarding our
anaerobic digestion bioenergy products still holds trade secret and other
proprietary information that is important to us. Prior to our ownership of
Microgy it experienced delays in obtaining and completing information necessary
to successfully develop anaerobic digester projects. The inability to readily
obtain this information from our licensor could delay our product offerings,
make them more expensive to bring to market and reduce the value of your
investment.
The market for anaerobic digester bioenergy technology is crowded and our market
share may not be sufficient to be profitable.
There are many companies that offer anaerobic digester systems. We believe
that at least 60 companies offer complete systems or components to these systems
in the U.S. market. The presence of these companies may dilute our market share
to a degree that we are not profitable.
We currently rely on the Scrubgrass Project for all of our operating revenues.
We own a 22 year leasehold interest that commenced in 1994 in our
Scrubgrass Project; a waste coal fired electric generating facility in
Pennsylvania. Because all of our operating revenue currently results from the
Scrubgrass Project, we are dependent on its successful and continued operating
experiences. Significant unscheduled shutdowns or large increases in interest
rates at Scrubgrass could reduce our cash flow. This may necessitate a
substantial curtailment of our operations and require the termination of any
anaerobic digester projects and would have an adverse effect on our results of
operations.
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We do not control the management of the Scrubgrass Project, our primary revenue
generating asset.
We have a management services agreement with PG&E National Energy Group to
manage the Scrubgrass Project and a 15-year operations and maintenance agreement
with PG&E Operating Services to operate the facility. Under the terms of these
agreements, there are provisions that limit our participation in the management
and operation of the Scrubgrass Project. Because we do not exercise control over
the operation or management of the Scrubgrass Project, decisions may be made,
notwithstanding our opposition that may have an adverse effect on our business.
Our current power generation revenue is derived from only one customer, the loss
of which would severely harm our financial condition and the value of your
investment.
Our current Scrubgrass Project power generation revenue is earned under a
long-term power purchase agreement with one customer, Pennsylvania Electric
Company, or Penelec. We expect that the concentration of our revenue with this
customer will continue for the foreseeable future. If this customer goes out of
business or defaults on its payments to us, our financial condition will be
adversely affected.
A large increase in interest rates may adversely affect our operating results.
Our Buzzard subsidiary is leveraged with variable rate and fixed rate debt
obligations. Should market interest rates rise significantly, our operating
results will be adversely impacted.
Our long term Scrubgrass Project power purchase agreement is subject to market
conditions in its later years which may affect our profitability.
The Scrubgrass Project generates electricity that is sold at rates
established under a long-term power purchase agreement with Penelec, approved by
the Pennsylvania Public Utility Commission. Contracted rates in the later years
of the agreement are determined with reference to then existing market
conditions. Therefore, low wholesale energy rates during the later years of the
power purchase agreement would negatively impact our profitability and could
affect our financial position.
Payment terms on our Scrubgrass Project will change in 2003 and, if our working
capital is not increased to satisfy the change, our cash available for other
uses will be significantly limited.
In 2003, the payment schedule on our power purchase agreement will be
modified to allow Penelec more time to pay us for the power that we produce.
This will reduce our working capital and could limit our ability to service our
debt or allocate resources to other projects.
We are a small company and the entrance of large companies into the alternative
fuels and renewable energy business will likely harm our business.
Competition in the traditional energy business from electric utilities and
other energy companies is well established with many substantial entities having
multi-billion dollar multi-national operations. Competition in the alternative
fuels and renewable energy business is expanding with growth of the industry and
advent of many new technologies. Larger companies,
27
due to their better capitalization, will be better positioned to develop new
technologies and to install existing or more advanced renewable energy
generators, which could harm our market share and business.
If we are unable to obtain sufficient waste resources our renewable energy
technologies will not likely operate profitably.
The performance of our renewable energy technologies is dependent on the
availability of certain waste resources to produce the raw energy and meet
performance standards in the generation of power or fuel. Lack of these waste
resources or adverse changes in the nature or quality of such waste resources
would seriously affect our ability to develop and finance projects and to
efficiently operate and generate income. As a result, our revenue and financial
condition will be materially and negatively affected. We cannot be sure that
waste resources will be available in the future for free or at a price that
make them affordable for our waste-to-energy technologies.
Our reliance on licenses, agreements and business alliances links our fate to
the fate of these businesses, of which we cannot predict or control.
We intend to rely on a network of various licenses, agreements and
alliances with other businesses to provide important technologies and services
for our businesses. Specifically, we rely on third party companies for the
operation and maintenance of our Scrubgrass facility and for the technology upon
which we base our proposed anaerobic digester projects. The termination of any
of these or other material license, agreement or business alliance will have a
detrimental impact on the success of one or all projects or categories of
projects and negatively impact our revenue. We cannot predict or control the
fate of these other businesses on which we rely.
Because we have not filed patents to protect Microgy's intellectual property, we
might not be able to prevent others from employing competing products.
Conversely, others who have filed for patent or other protection might be able
to prevent us from employing our products.
Neither we nor, it is believed, our primary licensor have filed any patent
applications on the intellectual property Microgy plans to use. Should we or our
primary licensor decide to file patent applications, there can be no assurance
that any patent applications relating to our existing or future products or
technologies will result in patents being issued, that any issued patents will
afford adequate protection to us, or that such patents will not be challenged,
invalidated, infringed or circumvented. Furthermore, there can be no assurance
that others have not developed, or will not develop, similar products or
technologies that will compete with our products without infringing upon, or
which do not infringe upon, our intellectual property rights.
Third parties, including potential competitors, may already have filed
patent applications relating to the subject matter of our current or future
products. In the event that any such patents are issued to such parties, such
patents may preclude our licensors from obtaining patent protection for their
technologies, products or processes. In addition, such patents may hinder or
prevent us from commercializing our products and could require us to enter into
licenses with
28
such parties. There can be no assurance that any required licenses would be
available to us on acceptable terms, or at all.
We rely heavily on confidentiality agreements and licensing agreements to
maintain the proprietary nature of our base of technologies relating to
currently licensed technologies. To compete effectively, we may have to defend
the rights to our intellectual property from time to time. The defense costs can
be significant. As such, we may lack the financial resources to adequately
defend our intellectual property.
Our license for microturbine technology is from a small company that has not
completed the development of the technology and is therefore of an uncertain
value.
Our Microgy subsidiary has entered into a license agreement for
applications of microturbine technology which is owned and being developed by
Electric Power International, Inc., which itself is a small company with limited
resources. Electric Power International has not yet completed development of the
microturbine technology and may not have the resources available to do so. The
value of this license agreement is of uncertain value.
The large amount of obstacles necessary to overcome for the development of power
projects increases the possibility that such projects will incur costly delays.
In our development of power projects for ourselves or on behalf of our
customers, we will be required to enter into or obtain some or all of the
following:
o site agreements;
o supply contracts;
o design/build or other construction related agreements;
o power sales contracts;
o various co-product sales agreements;
o waste disposal agreements;
o licenses;
o environmental and other permits;
o local government approvals; and
o financing commitments required for the successful completion of
development projects.
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Our failure to accomplish any of these objectives could materially increase
the cost or prevent the successful completion of development projects and incur
the loss of any investment made. These events could adversely affect our
business and results of operations.
System failure of our power generation projects will reduce our revenue.
Whether we have sold our facilities to customers or continue to own them,
our revenue and performance under various agreements will depend on the
efficient and uninterrupted operation of our bioenergy plants and systems,
including automated control systems. Any system failure that causes
interruptions in our operations in facilities that we have sold but continue to
manage could have an adverse effect on our business and results of operations.
Also, any system failure that causes interruptions in facilities that we own
could have a material adverse effect on our business, results of operations and
financial condition. As we expand our operations, there will be increased stress
placed upon hardware and information traffic management systems. There can be no
assurance that we will not experience system failures. In addition, our systems
and operations are vulnerable to damage or interruption from fire, flood, power
loss, telecommunications failure, break-ins and similar events. Our systems and
operations will also face contamination due to the actions of farmers and others
who may have access to our sites. We do not presently have redundant systems or
a formal disaster recovery plan to mitigate the risk of losses that may occur.
There can also be no assurance that any business interruption or property and
casualty insurance that we would carry in the future would be sufficient to
compensate for any losses that may occur.
Scheduled and unscheduled shutdowns of our power generation projects will reduce
our revenue.
Our Scrubgrass Project and any future power generation projects we develop
will experience both scheduled and unscheduled shutdowns. Periodically, power
generation projects incur scheduled shutdowns in order to perform maintenance
procedures to equipment that cannot be performed while the equipment is
operating. Occasionally, our power generation projects may also incur
unscheduled shutdowns and be required to temporarily cease operation or to
operate at reduced capacity levels following the detection of equipment
malfunctions, or following minimum generation orders received by the utility.
During periods when these projects shut down or are operating at reduced
capacity levels, we may incur losses due to reduced operating revenue and due to
additional costs that may be required to complete any maintenance procedures.
Our power generation entities expose us to significant liability that our
insurance cannot cover.
Our power generation activities involve significant risks to us for
environmental damage, equipment damage and failures, personal injury and fines
and costs imposed by regulatory agencies. In the event a liability claim is made
against us, or if there is an extended outage or equipment failure or damage at
our power plant for which it is inadequately insured or subject to a coverage
exclusion, and we are unable to defend such claim successfully or obtain
30
indemnification or warranty recoveries, there may be a material adverse effect
on our financial condition.
Poor fuel and other materials quality will expose us to environmental liability
and reduce our operating results.
For our Scrubgrass facility, we obtain waste coal primarily from coal
mining companies on a long-term basis because waste coal is plentiful and
generally creates environmental hazards, such as acid drainage, when not
disposed of properly. The waste coal is burned in the Scrubgrass facility using
a circulating fluidized bed combustion system. During the circulating fluidized
bed combustion process, the waste coal is treated with other substances such as
limestone. Depending on the quality of the waste coal and the limestone, the
facility operator may need to add additional waste coal or other substances to
create the appropriate balance of substances which would result in the best fuel
or sorbent consistency for power generation and compliance with air quality
standards. Therefore, the cost of generating power is directly impacted by the
quality of the waste coal which supplies the Scrubgrass power generation
facility. Certain conditions, such as poor weather, can create situations where
the facility operator has less control over the quality of the waste coal. Poor
fuel quality may impact our future operating results.
The composition of effluents from our anaerobic digester facilities is not
certain and may expose us to liability.
We do not have experience in blending the wastes that will occur in our
anaerobic digester facilities. Such blends could result in unpredictable
regulatory compliance costs, related liabilities and unwanted materials in waste
effluents and co products, all of which could harm our financial condition.
Our sale of power into unregulated and retail markets will likely subject our
revenue to large swings or prolonged depression of prices.
Electricity is a commodity available from a large amount of sources with no
pricing control. When we sell power under long term supply contracts or into the
unregulated wholesale and retail markets, we will be subject to very competitive
pricing pressures and market risks. Low energy rates would negatively impact the
Company's profitability and could adversely affect our financial condition.
Currently, we sell or have agreed to sell all of our power under existing long
term contracts. We are not certain of what form our future contracts will take.
The form of future contracts could subject us to unforeseen risks.
Our products and services involve long sales cycles that result in high costs
and uncertainty.
The negotiation of the large number of agreements necessary to sell,
develop, install, operate and manage any of our facilities, as well as to market
the energy and other co-products and to provide necessary related resources and
services, involves a long sales cycle and decision-making process. Delays in the
parties' decision-making process are outside of our control and may have a
negative impact on our cost of sales, receipt of revenue and sales projections.
We estimate that it can take from six months to a year or more to obtain
decisions and to negotiate and close these complex agreements.
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Because the market for renewable energy and waste management is unproven, it is
possible that we may expend large sums of money to bring our offering to market
and the revenue that we derive may be insufficient to fund our operations.
Our business approach to the renewable energy and waste management industry
may not produce results as anticipated, be profitable or be readily accepted by
the marketplace. We cannot estimate whether demand for our bio-energy products
will materialize at anticipated prices, or whether satisfactory profit margins
will be achieved. If such pricing levels are not achieved or sustained, or if
our technologies and business approach to the energy industry do not achieve or
sustain broad market acceptance, our business, operating results and financial
condition will be materially and negatively impacted.
If we violate performance guarantees granted to Penelec we will be required to
provide them with an incentive payment.
Our agreement for the sale of power to Penelec contains a provision that
requires our Scrubgrass facility to provide Pennsylvania Electric Company a
certain percentage of its average output over a given period of time. If we do
not comply with this performance guarantee, we will be required to compensate
Penelec with an incentive payment. The payment of an incentive payment would
have an adverse effect on our financial condition.
Our products and services will be subject to numerous governmental regulations.
We expect to provide services involving government regulation, which will
subject us to certain regulatory policies and procedures. Compliance with these
regulations could be costly and harm our financial condition. Many of these
regulations cover air and water quality and related pollution issues. These
regulations are mandated by the United States Environmental Protection Agency
and various state and local governments. More specifically, our activities in
anaerobic digestion and/or nutrient management related to animal manure, and
other wastes, as well as the air emissions and waste effluent control from our
facilities will involve a permitting process and other forms of scrutiny from
these agencies. In addition, our activities will fall under a number of health
and safety regulations and laws and regulations relating to farms and zoning.
Our power producing activities could be subject to costly regulations and
tariffs.
Our Scrubgrass facility and many of our planned bio-energy projects may or
do produce power for sale to the electric grid. As such, the sale of this power
may come under the regulations of various state public utility commissions.
These commissions set the price tariffs under which energy can be sold or
purchased and they set the design standards for the interconnection of power
producing equipment with the electric power grid. Most of our power projects
where electricity is sold to the grid will come under regulation by these
commissions. These regulations may impede or delay the process of approving and
implementing our projects. Substantial delays may materially affect our
financial condition.
Government regulations can be burdensome and may result in delays and
expense. In addition, modifications to regulations could adversely affect our
ability to sell power or to implement our chosen strategy for the sale of power.
Subsequent changes in the applicable
32
regulations could also affect our ability to sell or install new facilities or
develop and install facilities in an efficient manner or at all. Failure to
comply with applicable regulatory requirements can result in, among other
things, operating restrictions and fines which could harm our financial
condition.
We depend on a small number of key executives and our business could suffer if
they were to leave.
We employ a small group of skilled individuals to accomplish our goals. We
believe our performance is substantially dependent on the continued employment
and performance of our senior management. Many of these individuals are not
currently subject to employment agreements or employee non-compete agreements.
If we fail to retain the services of one or more of these persons, our business
could suffer significantly. We do not maintain key-man insurance on the life of
any of our officers at this time.
Our plans to enter into the anaerobic digester market will require the retention
of skilled employees and contractors, the success of which cannot be assured.
In order for us to enter into the anaerobic digester market we will be
required to hire and retain highly skilled employees and independent
contractors. It is anticipated that such persons may be difficult to locate and
engage. If we are not successful in hiring and retaining qualified persons, our
entrance into the anaerobic digester market will not likely be successful and
the value of your investment will be impaired.
Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our most significant market risk exposure is changing interest rates which may
affect our short-term investments, debt and certain of our lease expenses. We
offer the following information about these market risks:
Short-term investments - We invest cash balances which are in excess of our
normal operating requirements in short term investments generally with
maturities of 3 months of less. Because of the short duration of these
investments, we do not believe our short-term investments are subject to
material market risk.
Debt - We have borrowings which bear interest at variable rates which are based
on the London Interbank Offering Rate. We monitor market conditions for interest
rates and, from time to time, enter into interest rate swaps to manage our
interest payments. The interest rate swaps have the effect of converting the
variable rate borrowings to fixed rate borrowings for specified time periods.
Lease Expense - As a lease cost of the Scrubgrass Project, we are required to
fund the lessor's debt service which consists of fixed rate borrowings and
borrowings which bear interest at variable rates based on either quoted bond
rates or the London Interbank Offering Rate. The
33
manager of the Scrubgrass Project monitors market conditions for interest rates
and, from time to time, enters into interest rate swaps to manage the lessor's
interest payments for the Scrubgrass Project. The interest rate swaps have the
effect of converting the variable rate borrowings to fixed rate borrowings for
specified time periods.
As of June 30, 2002, the aggregate outstanding balance of our variable rate debt
obligations was $4,016,476. As of June 30, 2002, the aggregate outstanding
balance of the lessor's variable rate debt obligations, which are passed along
to us as a lease expense, was $143,628,572. Based on these balances, an
immediate change of one percent for the variable interest rates would cause a
change in interest expense of $40,165 and lease expense of $1,436,286. Our
objective in maintaining these variable rate borrowings is to achieve a lower
overall cost when compared to fixed-rate borrowings. We believe the lessor has
the same objective for maintaining their variable rate borrowings.
34
PART II. OTHER INFORMATION
ITEM 5. Other Information
On May 2, 2002, Benjamin Brant, a director of EPC and a former officer of our
Microgy subsidiary, granted to EPC a transferable one-year option to purchase
1,802,486 shares of his Common Stock at $0.35 per share. EPC is required to
exercise the option to purchase at least 342,857 of such shares by specified
times. To the extent any portion of the option expires unexercised, Mr. Brant
would grant EPC a transferable right of first refusal for the underlying shares
for a 12 month period beginning upon expiration of the option. Mr. Brant also
agreed to deliver an additional 197,514 shares of his Common Stock to EPC in
satisfaction of an obligation in the amount of $69,129 to Microgy by a company
of which Mr. Brant is a principal. Mr. Brant had previously guaranteed this
obligation to Microgy under a June 2001 agreement. Mr. Brant also agreed to a 24
month standstill whereby an additional 753,066 shares of his Common Stock would
not be sold into the public markets.
On May 3, 2002, EPC exercised options to purchase 120,000 shares of Mr. Brant's
Common Stock by a cash payment of $42,000. On May 3, 2002, Mr. Brant also
delivered 197,514 shares of his Common Stock to EPC in full satisfaction of the
obligation to Microgy described in the previous paragraph. In addition, on each
of May 17, 2002, June 25, 2002 and July 12, 2002, EPC made a monthly exercise of
the option to purchase 20,260 shares, or 60,780 shares in aggregate. We also
entered into a letter agreement dated July 11, 2002 (the "Brant Letter
Agreement") with Mr. Brant. The Brant Letter agreement permits us to exercise
the remaining portion of the option during a sixty day period ending September
9, 2002 (`the "Special Period") at the reduced exercise price of $0.25 per share
provided that the exercise is for at least one million of the 1,621,706
remaining option shares. Mr. Brant also agreed that an additional 50,000 shares
he owns would be subject to the option during the Special Period. Accordingly,
during the Special Period we have an option to repurchase between 1,000,000 and
1,671,706 shares of our Common Stock from Mr. Brant at a price of $0.25 per
share.
On August 13, 2002, we issued 790,000 units in a private placement at a price of
$1.00 per unit, or $790,000, in the aggregate. Each unit consists of one share
of newly issued common stock and one share of treasury common stock. An
aggregate of 1,580,000 shares were sold as part of the units, including 790,000
shares from treasury. As a result, our outstanding shares of common stock
increased from 19,873,109 to 21,453,109. The securities sold in the private
placement were not registered under the Securities Act of 1933 and were offered
and sold in the United States pursuant to an applicable exemption from the
registration requirements. The proceeds of the private placement are expected to
be used for working capital and general corporate purposes, including
development of Microgy's business.
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ITEM 6. Exhibits And Reports On Form 8-K
(a) Exhibits
(i) Exhibit 11 - Computation of Earnings Per Share.
(ii) Exhibit 10.76 - Letter agreement dated July 11, 2002 relating to
the Stock Option and right of First Refusal Agreement dated as of
May 2, 2002, by and between the Company and Benjamin Brant.
(Incorporated by reference to Exhibit 8 filed with Amendment No. 2
to the Schedule 13D of Benjamin Brant filed on July 22, 2002).
(iii) Exhibit 99.1 Certification of Chief Executive Officer pursuant to
18 U.S.C.ss.1350.
(iv) Exhibit 99.2 Certification of Chief Financial Officer pursuant to
18 U.S.C.ss.1350.
(b) Reports on Form 8-K
(i) On May 6, 2003, the Registrant disclosed pursuant to Regulation FD
a Letter to Shareholders of Environmental Power Corporation
("POWR"), dated May 6, 2002 to be included in the 2001 Annual
Report to shareholders.
(ii) On June 4, 2002, the Registrant disclosed pursuant to Regulation
FD a Letter to Shareholders of Environmental Power Corporation
("POWR"), dated May 30, 2002, to be included in First Quarter 2002
brochure to shareholders.
(iii) On June 4, 2002, the Registrant disclosed pursuant to Regulation
FD excerpts describing the business of Environmental Power
("POWR"), to be included in the 2001 Annual Report to
shareholders.
(iv) On June 25, 2002, the Registrant disclosed pursuant to Regulation
FD information contained in an Investor Fact Sheet
(v) On June 26, 2002, the Registrant disclosed pursuant to Regulation
FD a press release announcing that Environmental Power has been
named as 15th among New Hampshire's top 100 public companies by
BusinessNH Magazine for 2002 in their June issue.
(vi) On July 11, 2002, the Registrant disclosed pursuant to Regulation
FD a press release announcing a letter of intent agreement with
Wisconsin farmers to build anaerobic digesters.
(vii) On July 29, 2002, the Registrant disclosed pursuant to Regulation
FD a press release announcing the highlights of our annual
stockholders meeting held in Boston Massachusetts on July 25th
2002.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ENVIRONMENTAL POWER CORPORATION
August 14, 2001 /s/ R. Jeffrey Macartney
------------------------------------
R. Jeffrey Macartney
Treasurer and
Chief Financial Officer
(principal accounting officer
and authorized officer)
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