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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 September 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
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Environmental Power Corporation
(Exact name of registrant as specified in its charter)
Delaware 04-2782065
(State or other jurisdiction of (IRS Employer Identification
incorporation or organization) No.)
One Cate Street 4/th/ 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 November 13, 2002 21,892,579 shares
The Exhibit Index appears on Page 39.
Total number of pages is 42.
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ENVIRONMENTAL POWER CORPORATION
INDEX
PART I. FINANCIAL INFORMATION Page No.
--------
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets as
of September 30, 2002 (unaudited) and December 31, 2001 2
Condensed Consolidated Statements of Operations (unaudited)
for the Three and Nine Months Ended September 30, 2002 and
September 30, 2001 3
Condensed Consolidated Statements of Cash Flows (unaudited)
for the Nine Months Ended September 30, 2002 and September 30, 2001 4
Notes to Condensed Consolidated Financial Statements. 5-9
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 9-35
Item 3. Quantitative and Qualitative Disclosures About Market Risk 35
Item 4. Controls and Procedures 36
PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds 37
Item 4. Submission of Matters to a Vote of Security Holders 37
Item 5. Other Information 38
Item 6. Exhibits and Reports on Form 8-K 39
Signatures 40-42
1
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30 December 31
2002 2001
----------------- -----------------
ASSETS (Unaudited)
CURRENT ASSETS:
Cash and cash equivalents $ 596,900 $ 468,271
Restricted cash 923,842 1,014,580
Receivable from utility 8,620,084 7,905,864
Other current assets 701,664 607,590
----------------- -----------------
TOTAL CURRENT ASSETS 10,842,490 9,996,305
PROPERTY, PLANT AND EQUIPMENT, NET 934,164 652,830
LEASE RIGHTS, NET 2,049,750 2,161,503
ACCRUED POWER GENERATION REVENUES 68,556,991 63,648,995
GOODWILL 4,912,866 4,912,866
LICENSED TECHNOLOGY RIGHTS, NET 3,489,433 3,628,177
OTHER ASSETS 431,596 565,570
----------------- -----------------
TOTAL ASSETS $ 91,217,290 $ 85,566,246
================= =================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued expenses $ 7,713,352 $ 9,382,471
Secured promissory note payable to related party 750,000 750,000
Other current liabilities 2,097,260 1,363,108
----------------- -----------------
TOTAL CURRENT LIABILITIES 10,560,612 11,495,579
DEFERRED GAIN, NET 4,240,647 4,471,955
SECURED PROMISSORY NOTES PAYABLE
AND OTHER BORROWINGS 1,383,148 1,420,467
DEFERRED INCOME TAX LIABILITY 184,556 146,396
ACCRUED LEASE EXPENSES 68,556,991 63,648,995
----------------- -----------------
TOTAL LIABILITIES 84,925,954 81,183,392
----------------- -----------------
SHAREHOLDERS' EQUITY:
Preferred Stock ($.01 par value; 2,000,000 shares authorized as of
September 30, 2002 and December 31, 2001, respectively; no shares issued) 0 0
Preferred Stock (no par value, 10 shares authorized; 10 shares
issued as of September 30, 2002 and December 31, 2001, respectively) 100 100
Common Stock ($.01 par value; 50,000,000 shares authorized;
22,410,293 and 21,370,293 issued; and 21,912,839 and 20,251,653
outstanding as of September 30, 2002 and December 31, 2001) 224,103 213,702
Additional paid-in capital 7,665,601 6,850,046
Accumulated deficit (618,409) (1,518,390)
Accumulated other comprehensive loss (60,385) (60,385)
----------------- -----------------
7,211,010 5,485,073
Treasury stock (497,454 and 1,118,640 common shares, at cost, as of
September 30, 2002 and December 31, 2001) (273,726) (456,271)
Notes receivable from officers and board members (645,948) (645,948)
----------------- -----------------
TOTAL SHAREHOLDERS' EQUITY 6,291,336 4,382,854
----------------- -----------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 91,217,290 $ 85,566,246
================= =================
See Notes to Condensed Consolidated Financial Statements.
2
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended September 30 Nine Months Ended Septemebr 30
2002 2001 2002 2001
------------------- -------------------- ------------------- ------------------
POWER GENERATION REVENUES $ 14,683,232 $ 13,914,475 $ 40,773,693 $ 39,494,244
------------------- -------------------- ------------------- ------------------
COSTS AND EXPENSES:
Operating expenses 5,564,303 5,292,285 18,178,847 17,779,358
Lease expenses 5,332,121 5,988,593 18,407,178 17,862,716
General and administrative expenses 1,774,198 1,101,420 4,108,740 2,589,900
Depreciation and amortization 136,719 111,870 409,379 284,981
------------------- -------------------- ------------------- ------------------
12,807,341 12,494,168 41,104,144 38,516,955
------------------- -------------------- ------------------- ------------------
OPERATING INCOME (LOSS) 1,875,891 1,420,307 (330,451) 977,289
------------------- -------------------- ------------------- ------------------
OTHER INCOME (EXPENSE):
Interest income 12,350 17,944 34,382 59,688
Interest expense (41,355) (43,047) (111,916) (145,474)
Amortization of deferred gain 77,103 77,103 231,308 231,308
Sales of NOx emission credits 0 --- 2,428,200 ---
Other income 0 32,723 2,859 1,710,685
------------------- -------------------- ------------------- ------------------
48,098 84,723 2,584,833 1,856,207
------------------- -------------------- ------------------- ------------------
INCOME BEFORE INCOME TAXES 1,923,989 1,505,030 2,254,382 2,833,496
INCOME TAX EXPENSE (1,048,150) (583,000) (1,354,401) (1,141,000)
------------------- -------------------- ------------------- ------------------
NET INCOME $ 875,839 $ 922,030 $ 899,981 $ 1,692,496
=================== ==================== =================== ==================
OUTSTANDING:
Basic 20,600,872 15,547,945 20,298,245 12,802,339
Diluted 20,707,675 17,063,405 20,382,005 13,322,677
EARNINGS PER COMMON SHARE:
Basic $ 0.04 $ 0.06 $ 0.04 $ 0.13
Diluted $ 0.04 $ 0.05 $ 0.04 $ 0.13
See Notes to Condensed Consolidated Financial Statements.
3
ENVIRONMENTAL POWER CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Nine Months Ended September 30
2002 2001
---------------- ----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 899,981 $ 1,692,496
Adjustments to reconcile net income to net cash
Provided by (used in) operating activities:
Depreciation and amortization 409,379 284,981
Deferred income taxes 38,160 52,000
Amortization of deferred gain (231,308) (231,308)
Non-cash & Stock Based Compensation 49,706 3,916
Accrued power generation revenues (4,907,996) (5,595,636)
Accrued lease expenses 4,907,996 5,595,636
Changes in operating assets and liabilities:
Increase in receivable from utility (714,220) (716,219)
Increase in other current assets (113,593) (241,532)
Decrease (Increase) in other assets 107,244 (6,754)
(Decrease) increase in accounts payable and
accrued expenses (1,669,119) 303,984
Decrease in long-term debt to supplier 0 (94,411)
---------------- ----------------
Net cash provided by (used in)
operating activities (1,223,770) 1,047,153
---------------- ----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Decrease (Increase) in restricted cash 90,738 (217,927)
Acquisition related expenditures (210,465)
Property, plant and equipment expenditures (393,967) (1,000)
---------------- ----------------
Net cash used in investing activities (303,229) (429,392)
---------------- ----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Dividend payments (3,750) (174,852)
Private Placement Common Stock 780,000
Net borrowings (repayments) under working capital loan 734,152 (662,794)
Sale of Treasury Stock 182,545
Proceeds from short-term note payable 750,000
Advances on notes receivable from officers (200,000)
Repayment of secured promissory notes payable and
other borrowings (37,319) (76,974)
---------------- ----------------
Net cash generated (used) in financing activities 1,655,628 (364,620)
---------------- ----------------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 128,629 (253,141)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 468,271 307,666
---------------- ----------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 596,900 $ 560,807
================ ================
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 nine months ended September 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 nine months ended September 30, 2002 and
2001.
5
NOTE B -- EARNINGS PER COMMON SHARE (CONTINUED)
Income Shares Per Share
(Numerator) (Denominator) Amounts
------------- ------------- ---------
Three Months Ended September 30, 2002:
- --------------------------------------
Income available to shareholders $ 875,839 20,600,872
Effect of dividends to preferred stockholders of subsidiary (1,250)
------------ ------------ ---------
Basic EPS - Income attributable to common shareholders 874,589 20,600,872 $ 0.04
Effect of dilutive securities:
Assumed exercise of dilutive stock options 106,803
------------ ------------ ---------
Diluted EPS - Income attributable to common shareholders $ 874,589 20,707,675 $ 0.04
Three Months Ended September 30, 2001:
- --------------------------------------
Income attributable to shareholders $ 922,030 15,547,945
Effect of dividends to preferred stockholders of subsidiary (1,250)
------------ ------------ ---------
Basic EPS - Income attributable to common shareholders
920,780 15,547,945 $ 0.06
Effect of dilutive securities:
Assumed conversion of preferred stock 1,483,205
Assumed exercise of dilutive stock options 32,255
------------ ------------ ---------
Diluted EPS - Income attributable to common shareholders $ 920,780 17,063,405 $ .05
============ ============ =========
Income Shares Per Share
(Numerator) (Denominator) Amounts
------------- ------------- ---------
Nine Months Ended September 30, 2002:
- -------------------------------------
Income attributable to shareholders $ 899,981 20,298,245
Effect of dividends to preferred stockholders of subsidiary (3,750)
----------- ----------- ---------
Basic EPS - Income attributable to common shareholders 896,231 20,298,245 0.04
Effect of dilutive securities:
Assumed exercise of dilutive stock options 83,761
----------- ----------- ---------
Diluted EPS - Income attributable to common shareholders $ 896,230 20,382,005 $ 0.04
=========== =========== =========
Nine Months Ended September 30, 2001:
- -------------------------------------
Income attributable to shareholders $ 1,692,496 12,802,339
Effect of dividends to preferred stockholders of subsidiary (3,750)
----------- ----------- ---------
Basic EPS - Income attributable to common shareholders 1,688,746 12,802,339 0.13
Effect of dilutive securities:
Assumed conversion of preferred stock 499,835
Assumed exercise of dilutive stock options 20,503
----------- ----------- ---------
Diluted EPS - Income attributable to common shareholders $ 1,688,746 13,322,677 $ 0.13
=========== =========== =========
6
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 September 30, 2001 and
eliminates the pooling of interest method of accounting. SFAS 141 also broadens
the criteria for recording intangibles separate from 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 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 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 using 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
7
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.
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 goodwill or intangible assets recorded on
our balance sheet prior to the Microgy acquisition. Accumulated amortization of
licensed technology rights was $220,567 as of September 30, 2002 and $81,823 as
of December 31, 2001. Amortization expense for licensed technology rights was
$46,756 for the three months ended September 30, 2002, $138,744 for the nine
months ended September 30, 2002 and $-0- for the three and nine months ended
September 30, 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
============
8
NOTE E - SEGMENT INFORMATION
The Company manages and evaluates its operations in two reportable business
segments: Scrubgrass project and Microgy. These segments have been classified
separately by the chief operating decision maker because of the different
technologies used in the generation of energy and the future growth prospects of
those business technologies. Financial data for reportable business segments is
as follows:
Scrubgrass
Project Microgy Other Consolidated
------------------------------------------------------------
Three Months Ended September 30, 2002:
- --------------------------------------
Power generation revenues 14,683,232 -- -- 14,683,232
Pre-tax income 3,026,709 (897,902) (204,818) 1,923,989
Three Months Ended September 30, 2001:
- --------------------------------------
Power generation revenues 13,914,475 -- -- 13,914,475
Pre-tax income 2,163,022 (137,041) (520,951) 1,505,030
Scrubgrass
Project Microgy Other Consolidated
------------------------------------------------------------
Nine Months Ended September 30, 2002:
- -------------------------------------
Power generation revenues 40,773,693 -- -- 40,773,693
Pre-tax income 4,562,581 (2,039,837) (268,362) 2,254,382
Identifiable assets 82,065,756 8,494,181 657,353 91,217,290
Nine Months Ended September 30, 2001:
- -------------------------------------
Power generation revenues 39,494,244 -- -- 39,494,244
Pre-tax income 2,350,414 (137,041) 620,123 2,833,496
Identifiable assets 73,809,797 6,873,543 2,286,793 82,970,133
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.
9
Microgy's product is expected to provide U.S. farmers with a profitable solution
to an existing waste management problem that affects both water and air quality.
Federal and State agencies either have or may be in the process of passing
regulations that require U.S. farmers to implement changes to their current
waste management. While Microgy is seeking to help the farmers meet their waste
management needs with a profitable investment, we are also seeking to produce
renewable energy. Similar to the waste management issue many states have either
passed or may be in the process of reviewing legislation requiring utilities to
have a certain percentage of their power from renewable sources. This places
Microgy in the unique position of having a profitable solution to assist farmers
in solving a waste management problem, while at the same time providing a new
renewable energy source for utilities. Microgy represents a substantial portion
of the future potential growth of Environmental Power and as such we are
investing substantially all our available resources, both financial and human
capital, to take advantage of what we believe is a first mover advantage.
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 by the purchasers of certain contingent liabilities
of the company.
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 nine months ended September 30, 2002 with the results of operations for the
three and nine months ended September 30, 2001. Unless otherwise indicated, all
references to 2002 pertain to the nine months ended September 30, 2002 and all
references to 2001 pertain to the nine months ended September 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," "may," "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."
10
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.
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
11
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
September 30, 2002, we have a deferred lease expense of $68,556,991 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 $4,907,996 for the three and nine months ended
September 30, 2002, respectively, as compared to $1,865,214 and $5,595,636 for
the three and nine months ended September 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.
Our lease expense components, which are discussed in the following paragraphs,
consist of:
. specified base rent payments calculated on a straight-line basis;
. additional rent; and
. current period adjustments resulting from differences between actual lease
billings and projected lease billings.
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
12
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 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. As of September 30, 2002, we have accrued power
generation revenue of $68,556,991 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 $4,907,996 for the three and nine months
ended September 30, 2002, respectively, as compared to $1,865,214 and $5,595,636
for the three and nine months ended September 30, 2001, respectively. In the
later years of the power sales agreement, when the 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.
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
13
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 September 30, 2002, we
have recorded a net deferred income tax liability of $184,556 on our
consolidated balance sheet. We have also recorded a valuation allowance of
$148,377 against our gross deferred income tax assets as of September 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 three months ended September 30, 2002 amounted to $875,839 or
4 cents per share (basic and diluted), as compared to net income of $922,030, or
6 cents per share (basic) and 5
14
cents per share (diluted), for the three months ended September 30, 2001. The
decrease in net results during the three months ended September 30, 2002 is
primarily attributable to:
. an increase in operating, general and administrative expenses;
. decreased other income; and
. higher income tax expense.
The effect of these changes was offset in part by a decrease in:
. lease expenses; and
. an increase in power generation revenues.
Net income for the nine months ended September 30, 2002 amounted to $899,981 or
4 cents per share (basic and diluted); as compared to net income $1,692,496, or
13 cents per share (basic and diluted) for the nine months ended September 30,
2001. The decrease in net results during the nine months ended September 30,
2002 is primarily attributable to an increase in the following:
. operating expenses;
. income tax expense;
. lease expenses; and
. general expenses.
The effect of these changes was offset in part by an increase in:
. power generation revenues; and
. other income.
The reasons for these changes in our net results are discussed in more detail in
the following sections.
Revenues for the three and nine months ended September 30:
Power generation revenues for the three months ended September 30, 2002 amounted
to $14,683,232 as compared to $13,914,475 for the same period in 2001. The
increase in power generation revenues during the three months ended September
30, 2002 is primarily attributable to:
. a 5% increase in certain rates billed to Penelec under the terms of the
PPA.
. the plant operating at a higher capacity factor of 98.1% in 2002 compared
to 95.2% in 2001.
This increase was offset in part by a decrease:
. in the 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 September 30, 2002 and 2001,
respectively.
15
Power generation revenues for the nine months ended September 30, 2002 amounted
to $40,773,693, as compared to $39,494,244 for the same period in 2001. The
increase in power generation revenues during the nine months ended September 30,
2002 is primarily attributable:
. to a 5% increase in certain rates billed to Penelec under the terms of the
PPA; and
. the plant operating at a higher capacity factor of 90.4% in 2002 compared
to 89.7% in 2001.
This increase was offset in part by a decrease:
. in the revenue recorded as a result of the straight-line accounting
treatment of certain revenues under the PPA which amounted to $4,907,996
and $5,595,636 for the nine months ended September 30, 2002 and 2001,
respectively.
Operating expenses for the three and nine months ended September 30:
Operating expenses for the three months ended September 30, 2002 amounted to
$5,564,303 as compared to $5,292,285 for the same period in 2001. The increase
in operating expenses during the three months ended September 30, 2002 is
primarily attributable to:
. higher fuel costs primarily from cost escalations in certain fuel supply
agreements.
Operating expenses for the nine months ended September 30, 2002 amounted to
$18,178,847, as compared to $17,779,358 for the same period in 2001. The
increase in operating expenses during the nine months ended September 30, 2002
is primarily attributable to:
. higher fuel costs primarily from cost escalations in certain fuel supply
agreements.
Lease expenses for the three and nine months ended September 30:
Lease expenses for the three and nine months ended September 30, 2002 amounted
to $5,332,121 and $18,407,178, respectively, as compared to $5,988,593 and
$17,862,716 for the three and nine months ended September 30, 2001,
respectively.
The decrease in lease expenses during the three months ended September 30,
2002 is primarily attributable to the following reasons:
. The lessor's loan costs, which are passed along to the Company as a
lease expense, decreased due to the reductions in the following two
items:
. average variable interest rates; and
. outstanding principle balances on term loans.
. we incurred lower additional rents paid to the lessor.
The increase in lease expenses during the nine months ended September 30,
2002 is primarily attributable to the following reasons:
16
. we incurred scheduled increases in base equity rents paid to the
lessor; and
. the additional rents paid to the lessor, which amount to 50 percent
of the net cash flows from the Scrubgrass Project, amounted to
$3,769,824 for the nine months ended September 30, 2002, as compared
to $1,357,878 for nine months ended September 30, 2001.
This overall increase in lease expenses was offset in part by the following
decreases in certain other lease expenses during the nine months ended September
30, 2002:
. 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 $4,907,996 for nine months ended
September 30, 2002, as compared to $5,595,636 for the nine months ended
September 30, 2001; and
. 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:
. average variable interest rates; and
. outstanding principal balances on term loans.
General and administrative expenses for the three and nine months ended
September 30:
General and administrative expenses for the three and nine months ended
September 30, 2002 amounted to $1,774,198 and $4,108,740, respectively, as
compared to $1,101,420 and $2,589,900 for the three and nine months ended
September 30, 2001, respectively. The increases in general and administrative
expenses during the three and nine months ended September 30, 2002 were
primarily attributable to increases in most categories as a result of the
continued efforts to implement the Microgy business plan.
Other income and expenses for the three and nine months ended September 30:
Other income and expense for the three and nine months ended September 30, 2002
amounted to $48,098 and $2,584,833, respectively, as compared to $84,723 and
$1,856,207 for the three and nine months ended September 30, 2001, respectively.
The other income for the three months ended September 30, 2002 was primarily a
result of the amortization of the deferred gain from our 1990 sale of Scrubgrass
Power Corporation. The other income for the nine months ended September 30, 2002
was primarily the result of the sale of NOx emission credits for $2,428,200
during the first quarter of 2002.
Income tax expense for the three and nine months ended September 30:
Income tax expense amounted to, $1,048,150 and $583,000 for the three months
ended September 30, 2002 and 2001 respectively, and, $1,354,401 and $1,141,000
for the nine months ended September 30, 2002 and 2001 respectively. The increase
in income tax expense for the three and nine months ended September 30, 2002 is
primarily attributable to an increase in our Pennsylvania state tax due to
higher pre-tax earnings at our Scrubgrass Power Facility.
The effective income tax rate for year ended December 31, 2002 ("Fiscal 2002")
is currently projected to be approximately 60%, which is higher than the actual
tax rate of approximately 45% incurred during the year ended December 31, 2001
("Fiscal 2001"). Our taxable earnings are
17
significantly concentrated in Pennsylvania during Fiscal 2002, which state
carries the highest effective tax rate for the Company. Since we cannot
consolidate earnings for Pennsylvania state tax purposes, the expenses being
incurred to execute the Microgy plan are not deductible in Pennsylvania.
Segment Information:
When comparing our results for the nine month period ended September 30, 2002 to
the comparable period in 2001 it is important to note that Microgy Cogeneration
Systems was not part of our results until July 23, 2001. We have three business
subsidiaries that affected our consolidated results for the periods ending
September 30, 2002 and 2001. Each of these subsidiaries is at very different
stages of their business life cycle.
1. Scrubgrass:
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 $40,773,693 for the nine
months ended September 30, 2002 as compared to $39,494,244 for the comparable
period in 2001. Scrubgrass pre-tax income before consolidation was $4,562,581
for the nine month period ended September 30, 2002 as compared to $2,350,414 for
the comparable period in 2001. Additionally, Scrubgrass provided gross cash
flows to us of $3,776,536 for the nine month period ending September 30, 2002 as
compared to $1,341,407 for the comparable period in 2001.
To properly evaluate the improvement in Scrubgrass net income and cash flow for
the nine month period ending September 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. Year to
date as of September 30, 2002 the plant is operating at 90.4% capacity compared
to 89.7% for 2001.
2. Sunnyside (discontinued segment in 2001):
Also, we recognized $1,677,962 in the second quarter of 2001, 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. Sunnyside no longer has active operations.
3. Microgy:
In our newest subsidiary, Microgy Cogeneration Systems, which we acquired in
2001, we expect to build and operate systems that provide waste management and
power generation at confined animal operations. As a development stage company,
it requires EPC to make cash investments in the development and expansion of the
business. For the nine months ended September 30, 2002 Microgy had a pre-tax
loss of $2,039,837 as compared to $137,041 for the same period in 2001. The
increase in the pre-tax loss of $1,902,796 is attributable to implementing the
Microgy business plan and Microgy only being part of our operations for two of
the nine months in during the same nine month period in 2001. These costs are
incurred as we work with farms on
18
agreements to install our product, work with power companies to whom the farms
will sell power, with project financing sources to secure financing for the
projects and construction and engineering companies to build the projects.
This larger level of spending in the 2002 is one of the major reasons why our
net income for the three and nine month periods ending September 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 and increased production. This increase is expected to be 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:
. an escalation in rates for fuel supply agreements;
. changes in the scope of planned maintenance procedures and facility
modifications; and
. 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:
. we have scheduled increases in base equity rent payments; and
. 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:
. we expect the lessor to bill us lower scheduled loan principal
payments pursuant to the terms of the lease;
. 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
. 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:
. we have made and expect to make changes in our work force to seek to
develop and accomplish our Microgy business plan;
19
. we continue to employ consultants for technical, financial, legal,
marketing, public and investor relations and other strategic advice;
. Microgy corporate overhead will be included in our results of
operations for all of Fiscal 2002 versus for approximately five months
in Fiscal 2001; and
. we expect numerous corporate expenses like insurance, office supplies,
rent, legal, and travel to increase due to business expansion efforts.
Other income will increase slightly in Fiscal 2002. During Fiscal 2002, we will
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 were expected to increase 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 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 former director of EPC and former officer of Microgy.
Additionally, we have issued 1,040,000 new shares and sold an additional
1,040,000 shares from treasury in a private placement transaction on August 13
and September 19. As a result our outstanding common stock was 21,912,839 shares
as of November 14, 2002. Absent further new issuances or new share repurchases
from Mr. Brant after November 14, 2002, we would expect our weighted average
common shares outstanding in Fiscal 2002 to be approximately 21,700,104 shares.
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 (used in) operating activities of ($1,223,770) and
$1,047,153 during the nine months ended September 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 nine months ended September 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 nine months ended September 30, 2002 to
our net cash provided by operating activities:
20
. Depreciation and amortization - During the nine months ended September
30, 2002, we recognized depreciation for machinery and equipment
modifications and equipment and furniture of $112,633 and amortization
for lease rights of $111,753, deferred financing costs of $46,249 and
license technology rights of $138,744.
. Deferred gain, net - Our deferred gain, net, amounted to $4,240,647 as
of September 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
nine months ended September 30, 2002:
. Receivable from utility - Our receivable from utility relates to the
Scrubgrass Project and amounted to $8,620,084 as of September 30, 2002
as compared to $7,905,864 as of December 31, 2001. The increase in the
receivable from utility as of September 30, 2002 is primarily
attributable to the scheduled annual outage during the fourth quarter
of 2001, which reduced power generation revenues during that quarter
by comparison to the third quarter of 2002 which had no scheduled
outages. Also a 5% increase during 2002 of certain contracted rates
under the PPA contributed to the increase. Power generation revenues
are discussed further under "Results of Operations".
. Other current assets - Our other current assets amounted to $701,664
as of September 30, 2002 as compared to $607,590 as of December 31,
2001. The increase in other current assets is primarily attributable
to a seasonal increase in prepaid insurance. This increase was
partially offset by a decrease in on hand fuel inventories.
Accounts payable and accrued expenses - Our accounts payable and accrued
expenses amounted to $7,713,352 as of September 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:
. accrued bond interest due to the lessor decreased largely due to the
timing of bond maturities;
. certain costs which are paid annually during the first quarter and
accrued monthly during the calendar year had only nine months of
expense accrual as of September 30, 2002 versus 12 months of expense
accrual as of December 31, 2001.
The aforementioned decreases were offset in part by the following increase in
accounts payable and accrued expenses:
. corporate taxes payable increased from $1,157,066 as of December 31,
2001 to $1,304,571 as of September 30, 2002.
21
Investing Activities
We used $303,229 and $429,392 in investing activities during the nine months
ended September 30, 2002 and 2001, respectively. Our investing activities are
concentrated primarily in the following areas:
. 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 nine months ended September 30, 2002 and
2001, the balance of the restricted major maintenance fund was
increased by scheduled deposits and interest earnings on the deposit
of $821,061 and $633,485, respectively. Expenditures for major
equipment overhauls were $911,799 and $415,460 for the nine months
ended September 30, 2002 and September 30, 2001, respectively. 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.
. Property, plant and equipment - We made property, plant and equipment
expenditures of $393,967 and $1,000 during the nine months ended
September 30, 2002 and 2001, respectively. The 2002 purchases have
been comprised of $44,922 for office equipment at our corporate
headquarters and $349,045 for systems installed at our Scrubgrass
Plant.
Project development activities - We expect to begin development activities
during 2002 relating to the construction and sale of facilities using Microgy's
licensed technology. 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 costs were capitalized once the likelihood of
their recovery (for example, through future project's operating earnings or
through other reimbursement) is considered probable by management. During the
third quarter we determined that the financing structures of our projects may
require us to provide a certain level of equity or debt financing to of the
project. This would mean that we would not recover our indirect capitalized cost
for some indefinite period. Due to this change in circumstances surrounding the
recovery period of our indirect capitalized cost, we feel it is not appropriate
to capitalize expenses at this time. In the quarter ending September 30, 2002 we
did not capitalize any project expenses and reversed the $408,302 that we had
capitalized in the quarter ending June 30, 2002.
22
Financing Activities
The Company's financing activities provided $1,655,628 and used ($364,620) in
financing activities during the nine months ended September 30, 2002 and 2001,
respectively. The Company's financing activities are concentrated primarily in
the following areas:
. 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 maturity date of the loan was extended from September 14,
2002 to April 1, 2003.
. 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 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 $3,750 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 $3,750 in 2002 and $174,852 in 2001.
. Current 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 $1,948,950 as of
September 30, 2002 and $1,116,905 as of December 31, 2001. The Lessee
Working Capital Loan Agreement has been extended six years until in
December 2006. 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.
. Increased Working Capital Loan Requirement - During most of 2002, PG&E
National Energy Company, or NEG, the manager of Scrubgrass has been in
refinancing discussions with the lending agent for the project. Under
the terms of the project documents, NEG is not only a project
participant but is also the manager of the project with sole
responsibility and authority for discussions with project lenders. As
of the quarter ending September 2002, NEG's credit rating was
downgraded by the rating agencies. This may make loan refinancing more
difficult, even though the debt has recourse only to the Scrubgrass
project. NEG continues to address the financing matter regarding
Buzzard's expected requirement for additional working capital
beginning in August 2003, when Penelec's contracted payment
23
terms will be extended by 24 days. NEG was in discussions with Penelec
regarding paying a fee to them rather than extending the payment
terms. Subsequently Penelec has decided not to change the existing
agreement which will extend the payment terms in 2003. The lender
which recently approved an extension of the existing $4 million
working capital loan facility until 2006 was also approached to
increase the facility to $8 million to accommodate the change in the
Penelec payment terms. The lender has decided not to increase the loan
amount to accommodate this change. NEG is considering other
alternatives including possible factoring of the increased receivable,
extending payables and bringing in a new lending institution for
either the whole working capital requirement or the increased portion.
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 September 30, 2002 and December 31, 2001:
Balance at Balance at Matures
Description of the Obligation 9/30/02 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 9,195,664 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 948,428 985,747 LIBOR + 1.250% 2004
Working capital loan 1,948,950 1,116,905 LIBOR + 1.250% 2006
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 $202,826 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 September 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.
24
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/or expect to principally fund our
business activities from available cash balances, investment earnings, and
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 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 remainder of 2002.
On September 30, 2002, our unrestricted cash balance increased to $596,900 from
$468,271 as of December 31, 2001. On September 30, 2002, our restricted cash
balance decreased to $923,842 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 September 30, 2002, we have received year-to-date distributions from
Scrubgrass of $3,776,536 compared to distributions of $1,341,407 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 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 and for the plant to continue to operate and produce
power revenues at record levels in 2003.
25
As a result of the power contract originally negotiated between the parties in
1987, Penelec's payment terms will automatically be extended in June of 2003
from the current 23 business days after month end to 47 business days after
month end. As a result, Buzzard will incur a need for increased working capital.
In the event no additional credit accommodation is arranged for the increased
working capital requirements at the Scrubgrass plant, our cash flow for 2003 may
not be sufficient to fund:
. EPC's historic corporate overhead requirements;
. taxes;
. continued expansion of the Microgy business plan; and
. repayment of the Alco loan to the extent the loan is not refinanced or
replaced.
As discussed above under Refinancing at Scrubgrass, we are working with NEG, the
manager of the plant, to develop solutions to our increased working capital
requirements. Also as detailed below we are soliciting interest with various
potential sources of debt or equity funding. Assuming that we are able to
implement a solution to support our increased working capital needs and/or are
successful in raising additional debt or equity funding, we should have
sufficient cash flow to support:
. EPC's historic corporate overhead requirements;
. taxes; and
. repayment of the Alco loan to the extent the loan is not refinanced or
replaced.
During the quarter ended September 30, 2002, we raised $1,040,000 before
expenses, in a private placement of an aggregate of 2,080,000 shares of our
common stock, including 1,040,000 treasury shares. However, our existing sources
of cash are not adequate to implement our current business plan for Microgy. 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 exploring
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 development process relating to
the construction and sale 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
26
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.
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 $3,131,927 through September 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.
27
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 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.
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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.
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.
29
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, 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.
30
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 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:
. site agreements;
. supply contracts;
. design/build or other construction related agreements;
. power sales contracts;
. various co-product sales agreements;
31
. waste disposal agreements;
. licenses;
. environmental and other permits;
. local government approvals; and
. financing commitments required for the successful completion of
development projects.
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
32
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
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
33
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 nine months to a year or more to obtain
decisions and to negotiate and close these complex agreements.
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.
34
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 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:
35
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 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 September 30, 2002, the aggregate outstanding balance of our variable rate
debt obligations was $3,647,378. As of September 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 $36,474 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.
Item 4. CONTROL AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Chief Financial Officer, we evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures (as defined in Rule [13a-14(c)/15d-14(c)] under the Exchange Act) as
of a date (the "Evaluation Date") within 90 days prior to the filing date of
this report. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of the Evaluation Date, our disclosure
controls and procedures are effective in timely alerting them to the material
information relating to us (or our consolidated subsidiaries) required to be
included in our periodic SEC filings.
(b) Changes in internal controls.
There were no significant changes made in our internal controls during the
period covered by this
36
report or, to our knowledge, in other factors that could significantly affect
these controls subsequent to the date of their evaluation.
PART II. OTHER INFORMATION
ITEM 2. Changes in Securities and Use of Proceeds.
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 issued on August
13, including 790,000 shares from treasury. As a result, our outstanding shares
of common stock increased from 19,873,359 to 21,453,359.
On September 19, 2002, we issued an additional 250,000 units in such private
placement at a price of $1.00 per unit, or $250,000, in the aggregate. An
aggregate of 500,000 shares were sold as part of the units issued on September
19, including 250,000 shares from treasury. As a result, our outstanding shares
of common stock further increased from 21,412,839 to 21,912,839.
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.
ITEM 4. Submission of Matters to a Vote of Security Holders
At our 2002 Annual Meeting of Stockholders, held on July 25, 2002, the
following actions were submitted to a vote of security holders:
1. Our stockholders elected a Board of Directors to serve for the ensuing
year until their respective successors have been duly elected and
qualified. The results of the voting were as follows:
Number of Shares
Elected Director For Withheld
---------------- --- --------
Joseph E. Cresci 15,234,325 69,787
Donald A. Livingston 15,284,325 19,787
Peter J. Blampied 15,284,325 19,787
Robert I. Weisberg 15,284,325 19,787
Thomas Matthews 15,284,325 19,787
Herman Brubaker 15,284,325 19,787
Jessie J. Knight, Jr. 15,284,325 19,787
August Schumacher, Jr. 15,284,325 19,787
On August 30, 2002, Herman Brubaker resigned from the Board for personal
reasons.
37
2. Our stockholders approved the adoption of the Corporation's 2002
Director Option Plan. The results of the voting were as follows:
Result Number of Shares
------ ----------------
For ....................................... 2,621,539
Against ................................... 278,776
Abstain ................................... 55,429
3. Our stockholders ratified the reappointment of the firm of Deloitte
& Touche LLP as independent auditors of the Corporation for the fiscal
year ending December 31, 2002. The results of the voting were as
follows:
Result Number of Shares
------ ----------------
For ....................................... 15,114,540
Against ................................... 136,056
Abstain ................................... 53,516
ITEM 5. Other Information
On May 2, 2002, Benjamin Brant, a former 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 July 12, 2002, August 26, September 18, and
October 16, EPC made a monthly exercise of the option to purchase 20,260 shares,
or 121,560 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 permitted us to exercise
the remaining portion of the option during a ninety 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 had the
38
right 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. We did not exercise such right
during the Special Period and the right expired on September 9, 2002.
Accordingly, our option continues at an exercise price of $0.35 per share.
ITEM 6. Exhibits And Reports On Form 8-K
(a) Exhibits
(i) Exhibit 11 - Computation of Earnings Per Share.
(ii) Exhibit 99.1 Certification of Chief Executive Officer pursuant to
18 U.S.C.(S)1350.
(iii) Exhibit 99.2 Certification of Chief Financial Officer pursuant to
18 U.S.C.(S)1350.
(b) Reports on Form 8-K
(i) On August 15, 2002, the Registrant disclosed pursuant to Regulation
FD a Letter to Shareholders of Environmental Power Corporation
("POWR"), dated August 15, 2002 to be included in the Second
Quarter 2002 brochure to shareholders.
(ii) On August 15, 2002, the Registrant disclosed pursuant to regulation
FD an earnings release of Environmental Power Corporation ("POWR"),
dated August 15, 2002.
(iii) On October 15, 2002, the Registrant disclosed pursuant to
Regulation FD a press release announcing that Environmental Power
Corporation ("POWR") had signed a memorandum of understanding with
Vermont Public Power Supply Authority (VPPSA) for the construction,
sale and operation of anaerobic digester/electric generation
facilities in New England and New York
39
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
November 13, 2002 /s/ R. Jeffrey Macartney
-------------------------------
R. Jeffrey Macartney
Treasurer and
Chief Financial Officer
(principal accounting officer
and authorized officer)
SECTION 302 CERTIFICATIONS
I, Joseph E. Cresci, certify that:
1. I have reviewed this quarterly report of Environmental Power
Corporation;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary in order to make the statements made in light of the
circumstances under which such statements were made, not misleading
with respect to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which the
quarterly report is being prepared;
40
. evaluated the effectiveness of the issuer's disclosure controls
and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):
. all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in
this quarterly report whether or not there were significant
changes in internal controls or in other factors that could
significantly affect internal controls subsequent to the date of
our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
/s/ Joseph E. Cresci
--------------------
Joseph E. Cresci
Chief Executive Officer
November 13, 2002
I, R. Jeffrey Macartney, certify that:
1. I have reviewed this quarterly report of Environmental Power
Corporation;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary in order to make the statements made in light of the
circumstances under which such statements were made, not misleading
with respect to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included
41
in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly
report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant
and we have:
. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which the
quarterly report is being prepared;
. evaluated the effectiveness of the issuer's disclosure controls
and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on
our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):
. all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's
ability to record, process, summarize and report financial data
and have identified for the registrant's auditors any material
weaknesses in internal controls; and
. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent
evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.
/s/ R. Jeffrey Macartney
------------------------
R. Jeffrey Macartney
Chief Financial Officer
November 13, 2002
42