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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
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 1-31449
TEXAS GENCO HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
TEXAS 76-0695920
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1111 LOUISIANA
HOUSTON, TEXAS 77002
(Address of principal executive offices) (Zip Code)
(713) 207-1111
(Registrant's telephone number, including area code)
------------------------------
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 [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of August 4, 2003, Texas Genco Holdings, Inc. (Texas Genco) had
80,000,000 shares of common stock outstanding, including 64,764,240 shares which
were held by Utility Holding, LLC, a wholly owned subsidiary of CenterPoint
Energy, Inc.
1
TEXAS GENCO HOLDINGS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2003
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements...................................................................... 1
Statements of Consolidated Operations
Three Months and Six Months Ended June 30, 2002 and 2003 (unaudited)....................... 1
Consolidated Balance Sheets
December 31, 2002 and June 30, 2003 (unaudited)............................................ 2
Statements of Consolidated Cash Flows
Six Months Ended June 30, 2002 and 2003 (unaudited)........................................ 3
Notes to Unaudited Consolidated Financial Statements.......................................... 4
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..... 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk................................ 24
Item 4. Controls and Procedures................................................................... 25
PART II. OTHER INFORMATION
Item 1. Legal Proceedings......................................................................... 26
Item 4. Submission of Matters to a Vote of Security Holders....................................... 26
Item 5. Other Information......................................................................... 26
Item 6. Exhibits and Reports on Form 8-K.......................................................... 35
i
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
From time to time we make statements concerning our expectations, beliefs,
plans, objectives, goals, strategies, future events or performance and
underlying assumptions and other statements that are not historical facts. These
statements are "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Actual results may differ materially
from those expressed or implied by these statements. You can generally identify
our forward-looking statements by the words "anticipate," "believe," "continue,"
"could," "estimate," "expect," "forecast," "goal," "intend," "may," "objective,"
"plan," "potential," "predict," "projection," "should," "will," or other similar
words.
We have based our forward-looking statements on our management's beliefs and
assumptions based on information available to our management at the time the
statements are made. We caution you that assumptions, beliefs, expectations,
intentions and projections about future events may and often do vary materially
from actual results. Therefore, we cannot assure you that actual results will
not differ materially from those expressed or implied by our forward-looking
statements.
The following are some of the factors that could cause actual results to
differ materially from those expressed or implied in forward-looking statements:
- state and federal legislative and regulatory actions or developments,
including deregulation; re-regulation and restructuring of the market
served by the Electric Reliability Council of Texas, Inc. (ERCOT
market), constraints placed on our activities or business by the Public
Utility Holding Company Act of 1935, as amended (1935 Act) and changes
in, or application of, environmental and other laws or regulations to
which we are subject;
- the effects of competition, including the entry of additional
competitors in the ERCOT market and the construction of additional
generating stations by competitors;
- the results of our capacity auctions;
- the timing and extent of changes in commodity prices, particularly
natural gas;
- weather variations and other natural phenomena;
- unanticipated changes in operating expenses and capital expenditures;
- financial distress of our customers, including Reliant Resources, Inc.;
- our access to capital and credit;
- any lack of effectiveness of our disclosure controls and procedures;
- political, legal and economic conditions and developments in the United
States; and
- other factors we discuss in this report, including those outlined in
Item 5 of Part II under "Risk Factors."
You should not place undue reliance on forward-looking statements. Each
forward-looking statement speaks only as of the date of the particular
statement, and we undertake no obligation to publicly update or revise any
forward-looking statements.
ii
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
TEXAS GENCO HOLDINGS, INC.
STATEMENTS OF CONSOLIDATED OPERATIONS
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
----------------------------------- ------------------------------
2002 2003 2002 2003
---------------- ------------- ------------- -------------
REVENUES:
Energy revenues................................... $ 306,327 $ 378,402 $ 546,809 $ 602,166
Capacity and other revenues....................... 107,321 200,109 192,486 334,932
---------------- ------------- ------------- -------------
Total........................................ 413,648 578,511 739,295 937,098
---------------- ------------- ------------- -------------
EXPENSES:
Fuel costs........................................ 295,241 349,318 476,224 557,307
Purchased power................................... 4,258 22,974 52,624 34,968
Operation and maintenance......................... 78,906 105,301 173,615 210,651
Depreciation and amortization..................... 38,601 39,391 78,932 78,470
Taxes other than income taxes..................... 25,764 11,483 38,778 22,774
---------------- ------------- ------------- -------------
Total........................................ 442,770 528,467 820,173 904,170
---------------- ------------- ------------- -------------
OPERATING INCOME (LOSS)............................. (29,122) 50,044 (80,878) 32,928
OTHER INCOME........................................ 2,902 1,089 2,904 1,289
INTEREST EXPENSE, NET............................... 7,962 2,822 15,951 5,625
---------------- ------------- ------------- -------------
INCOME (LOSS) BEFORE INCOME TAXES AND CUMULATIVE
EFFECT OF ACCOUNTING CHANGE....................... (34,182) 48,311 (93,925) 28,592
INCOME TAX BENEFIT (EXPENSE)........................ 15,890 (15,018) 40,939 (6,181)
---------------- ------------- ------------- -------------
INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF
ACCOUNTING CHANGE................................. (18,292) 33,293 (52,986) 22,411
CUMULATIVE EFFECT OF ACCOUNTING CHANGE,
NET OF TAX........................................ -- -- -- 98,910
---------------- ------------- ------------- -------------
NET INCOME (LOSS)................................... $ (18,292) $ 33,293 $ (52,986) $ 121,321
================ ============= ============= =============
BASIC AND DILUTED EARNINGS PER SHARE:
Income (Loss) Before Cumulative Effect of
Accounting Change.............................. $ (0.23) (0.66) $ 0.28
Cumulative Effect of Accounting Change, net of $ 0.42 $
tax............................................ -- -- -- 1.24
---------------- ------------- ------------- -------------
Net Income (Loss)................................ $ (0.23) $ 0.42 $ (0.66) $ 1.52
================ ============= ============= =============
See Notes to the Company's Interim Financial Statements
1
TEXAS GENCO HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
DECEMBER 31, JUNE 30,
------------- -------------
2002 2003
------------- -------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents........................................................ $ 578 $ 154
Customer accounts receivable..................................................... 68,604 171,900
Accounts receivable, other....................................................... 4,544 7,169
Materials and supplies........................................................... 92,869 91,374
Fuel stock and petroleum products................................................ 63,298 78,866
Prepaid expenses and other current assets........................................ 4,024 9,509
------------- -------------
Total current assets........................................................ 233,917 358,972
------------- -------------
PROPERTY, PLANT AND EQUIPMENT, NET................................................. 3,980,770 4,146,855
------------- -------------
OTHER ASSETS:
Nuclear decommissioning trust.................................................... 162,576 173,845
Other............................................................................ 11,584 14,476
------------- -------------
Total other assets.......................................................... 174,160 188,321
------------- -------------
TOTAL ASSETS............................................................. $ 4,388,847 $ 4,694,148
============= =============
LIABILITES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable - affiliated companies, net.................................... $ 22,652 $ 11,276
Accounts payable, fuel........................................................... 76,399 142,355
Accounts payable, other.......................................................... 43,877 57,783
Notes payable - affiliated companies, net....................................... 86,186 128,643
Taxes and interest accrued....................................................... 38,591 41,854
Deferred capacity auction revenue................................................ 48,721 89,008
Other............................................................................ 15,918 11,353
------------- -------------
Total current liabilities................................................... 332,344 482,272
------------- -------------
OTHER LIABILITIES:
Accumulated deferred income taxes, net........................................... 813,246 856,384
Unamortized investment tax credit................................................ 170,569 164,496
Nuclear decommissioning reserve.................................................. 139,664 191,242
Benefit obligations.............................................................. 15,751 17,086
Accrued reclamation costs........................................................ 39,765 3,991
Notes payable - affiliated companies, net....................................... 18,995 19,006
Other............................................................................ 34,470 54,306
------------- -------------
Total other liabilities..................................................... 1,232,460 1,306,511
------------- -------------
COMMITMENTS AND CONTINGENCIES (NOTE 4)
SHAREHOLDERS' EQUITY:
Common stock (80,000,000 shares outstanding at December 31, 2002 and June 30,
2003, respectively)............................................................ 1 1
Additional paid-in capital....................................................... 2,878,502 2,878,502
Retained earnings (deficit)...................................................... (54,460) 26,862
------------- -------------
Total Shareholders' Equity.................................................. 2,824,043 2,905,365
------------- -------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY............................... $ 4,388,847 $ 4,694,148
============= =============
See Notes to the Company's Interim Financial Statements
2
TEXAS GENCO HOLDINGS, INC.
STATEMENTS OF CONSOLIDATED CASH FLOWS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
SIX MONTHS ENDED JUNE 30,
-------------------------------
2002 2003
------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)............................................ $ (52,986) $ 121,321
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization............................. 78,932 78,470
Fuel-related amortization................................. 9,019 9,725
Deferred income taxes..................................... (14,870) (10,121)
Investment tax credit..................................... (6,616) (6,073)
Cumulative effect of accounting change.................... -- (98,910)
Changes in other assets and liabilities:
Accounts receivable..................................... (27,086) (105,921)
Accounts receivable, affiliate.......................... (101,492) --
Inventory............................................... 15,393 (14,073)
Accounts payable........................................ (11,211) 79,862
Accounts payable, affiliate............................. -- (11,378)
Taxes and interest accrued.............................. (91,805) 3,263
Accrued reclamation costs............................... 753 3,898
Benefit obligations..................................... (21,056) 1,335
Deferred revenue from capacity auctions................. 78,958 40,287
Other current assets.................................... (2,469) (5,485)
Other current liabilities............................... (3,861) (4,565)
Other long-term assets.................................. 1,288 (2,962)
Other long-term liabilities............................. 42 (6,861)
------------- -------------
Net cash provided by (used in) operating activities.. (149,067) 71,812
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures......................................... (142,920) (74,706)
------------- -------------
Net cash used in investing activities................ (142,920) (74,706)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payment of common stock dividends............................ -- (40,000)
Net change in capitalization activity........................ 202,563 --
Increase in short-term notes payable, affiliate.............. 89,641 42,459
Increase in long-term notes payable, affiliate............... -- 11
------------- -------------
Net cash provided by financing activities............ 292,204 2,470
------------- -------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........... 217 (424)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD............... -- 578
------------- -------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD..................... $ 217 $ 154
============= =============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash Payments:
Interest..................................................... $ 797 $ 5,432
Income taxes................................................. -- --
See Notes to the Company's Interim Financial Statements
3
TEXAS GENCO HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS
(1) BACKGROUND AND BASIS OF PRESENTATION
General. Included in this Quarterly Report on Form 10-Q of Texas Genco
Holdings, Inc. (Texas Genco or the Company) are the Company's consolidated
interim financial statements and notes (Interim Financial Statements), which
include its wholly owned subsidiaries. The Interim Financial Statements are
unaudited, omit certain financial statement disclosures and should be read with
the Annual Report on Form 10-K of Texas Genco (Texas Genco Form 10-K) for the
year ended December 31, 2002 and the Quarterly Report on Form 10-Q of Texas
Genco for the quarter ended March 31, 2003.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America (GAAP) requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
The Company's Interim Financial Statements reflect all normal recurring
adjustments that are, in the opinion of management, necessary to present fairly
the financial position and results of operations for the respective periods.
Amounts reported in the Company's Statements of Consolidated Operations are not
necessarily indicative of amounts expected for a full year period due to the
effects of, among other things, (a) seasonal variations in energy consumption,
(b) timing of maintenance and other expenditures and (c) acquisitions and
dispositions of assets and other interests.
Background. In June 1999, the Texas legislature enacted an electric
restructuring law that substantially amended the regulatory structure governing
electric utilities in Texas in order to encourage retail electric competition.
Reliant Energy, Incorporated (Reliant Energy) submitted a restructuring proposal
to the Public Utility Commission of Texas (Texas Utility Commission) in response
to the law. Texas Genco was formed in August 2001 to hold the portfolio of
generating facilities previously owned by the unincorporated electric utility
division of Reliant Energy.
In August 2002, Reliant Energy conveyed all of its electric generating
facilities to the Company, which was accounted for as a business combination of
entities under common control. The Company subsequently became an indirect
wholly owned subsidiary of CenterPoint Energy, Inc. (CenterPoint Energy). As
used herein, CenterPoint Energy also refers to the former Reliant Energy for
dates prior to the restructuring.
CenterPoint Energy is a registered public utility holding company under the
Public Utility Holding Company Act of 1935, as amended (1935 Act). The 1935 Act
and related rules and regulations impose a number of restrictions on the
activities of CenterPoint Energy and its subsidiaries. The 1935 Act, among other
things, limits the ability of the holding company and its subsidiaries to issue
debt and equity securities without prior authorization, restricts the source of
dividend payments to funds from current and retained earnings without prior
authorization, regulates sales and acquisitions of certain assets and businesses
and governs affiliate transactions.
Basis of Presentation. The consolidated financial statements include the
operations of Texas Genco and its subsidiaries, which manage and operate the
Company's electric generation operations. Beginning January 1, 2002, CenterPoint
Energy's generation business was segregated from CenterPoint Energy's electric
utility as a separate reporting business segment and began selling electricity
in the Texas deregulated electricity market (ERCOT market) at prices determined
by the market. Accordingly, the net income (loss) before cumulative effect of
accounting change reflects the results of market prices for power. Included in
operations are allocations from CenterPoint Energy for corporate services that
included accounting, finance, investor relations, planning, legal,
communications, governmental and regulatory affairs and human resources, as well
as information technology services and other services such as corporate
security, facilities management, accounts receivable, accounts payable
4
and payroll, office support services and purchasing and logistics. From January
1, 2002 through the Company's acquisition of its generation facilities in August
31, 2002, various allocation methodologies were employed to separate the results
of operations and financial condition of the generation-related portion of
CenterPoint Energy's business from CenterPoint Energy's historical financial
statements. Interest expense was calculated based on an allocation methodology
that charged the Company with financing and equity costs of CenterPoint Energy
in proportion to the Company's share of total net assets. Interest expense in
2002 through August 31, 2002 was allocated based upon the remaining electric
utility debt not specifically identified with Reliant Energy's transmission and
distribution utility upon deregulation. Effective with the restructuring of
Reliant Energy, no long-term debt was assumed by the Company and interest is
incurred on borrowings from CenterPoint Energy. Management believes these
allocation methodologies to be reasonable. Had the Company actually existed as a
separate company prior to August 31, 2002, its results could have significantly
differed from those presented herein.
Texas Genco's Board of Directors declared an 80,000-for-one stock split that
was effected on December 18, 2002. On January 6, 2003, CenterPoint Energy
distributed approximately 19% of the 80 million outstanding shares of Texas
Genco's common stock to CenterPoint Energy's shareholders. Earnings per share
for 2002 has been presented as if the 80 million shares were outstanding in
accordance with Statement of Financial Accounting Standards (SFAS) No. 128,
"Earnings Per Share." The number of shares outstanding for purposes of computing
both basic and diluted earnings per share is 80 million for the three months and
six months ended June 30, 2002 and 2003.
The Company declared and paid a dividend of $0.25 per share of common stock
in both the first and second quarters of 2003.
The following notes to the consolidated annual financial statements in the
Texas Genco Form 10-K (Texas Genco Notes) relate to certain contingencies. These
notes, as updated herein, are incorporated herein by reference:
Texas Genco Notes: Note 2(f) (Long-Lived Assets and Intangibles), 2(h)
(Reclamation Costs) and Note 8 (Commitments and Contingencies).
For information regarding certain environmental matters and legal
proceedings, see Note 4 herein.
(2) NEW ACCOUNTING PRONOUNCEMENTS
Effective January 1, 2003, the Company adopted SFAS No. 143, "Accounting for
Asset Retirement Obligations" (SFAS No. 143). SFAS No. 143 requires the fair
value of an asset retirement obligation to be recognized as a liability is
incurred and capitalized as part of the cost of the related tangible long-lived
assets. Over time, the liability is accreted to its present value each period,
and the capitalized cost is depreciated over the useful life of the related
asset. Retirement obligations associated with long-lived assets included within
the scope of SFAS No. 143 are those for which a legal obligation exists under
enacted laws, statutes and written or oral contracts, including obligations
arising under the doctrine of promissory estoppel.
The Company has identified retirement obligations for nuclear
decommissioning at the South Texas Project Electric Generating Station (South
Texas Project) and for lignite mine operations at the Jewett mine supplying the
Limestone electric generation facility. Prior to adoption of SFAS No. 143, the
Company had recorded liabilities for nuclear decommissioning and the reclamation
of the lignite mine. Liabilities were recorded for estimated decommissioning
obligations of $139.7 million and $39.7 million for reclamation of the lignite
at December 31, 2002. Upon adoption of SFAS No. 143 on January 1, 2003, the
Company reversed the $139.7 million previously accrued for the nuclear
decommissioning of the South Texas Project and recorded a plant asset of $99.1
million offset by accumulated depreciation of $35.8 million as well as a
retirement obligation of $186.7 million. The $16.3 million difference between
amounts previously recorded and the amounts recorded upon adoption of SFAS No.
143 is being deferred as a liability as the recovery of nuclear decommissioning
costs continues to be regulated by the Texas Utility Commission. Accordingly,
any difference between assets and liabilities associated with nuclear
decommissioning are recorded as a receivable or liability as such amount will be
funded by or returned to customers of CenterPoint Houston or its successor (see
Note 4(a)). The Company also reversed the $39.7 million it had previously
recorded for the Jewett mine reclamation and recorded a plant asset of $1.9
million offset by accumulated depreciation of $0.4 million as well as a
retirement obligation of $3.8 million. The $37.4 million difference between
amounts previously recorded and the amounts recorded upon adoption of SFAS No.
143 was recorded as a
5
cumulative effect of accounting change. The Company has also identified other
asset retirement obligations that cannot be estimated because the assets
associated with the retirement obligations have an indeterminate life.
The following represents the balances of the asset retirement obligation as
of January 1, 2003 and the additions and accretion of the asset retirement
obligation for the six months ended June 30, 2003:
BALANCE, LIABILITIES LIABILITIES CASH FLOW BALANCE,
JANUARY 1, 2003 INCURRED SETTLED ACCRETION REVISIONS JUNE 30, 2003
---------------- ----------- ----------- --------- --------- -------------
(IN MILLIONS)
Nuclear decommissioning.... $ 186.7 -- -- $ 4.5 -- $ 191.2
Jewett lignite mine........ 3.8 -- -- 0.2 -- 4.0
--------------- ------------ ----------- --------- --------- -------------
$ 190.5 -- -- $ 4.7 -- $ 195.2
=============== ============ =========== ========= ========= =============
The following represents the pro-forma effect on the Company's net income
for the three months and six months ended June 30, 2002, as if the Company had
adopted SFAS No. 143 as of January 1, 2002:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2002 JUNE 30, 2002
------------------ ----------------
(IN THOUSANDS)
Net loss as reported .................................. $ (18,292) $ (52,986)
Pro-forma net loss..................................... (18,104) (52,608)
DILUTED EARNINGS PER SHARE:
Net loss as reported .................................. $ (0.23) $ (0.66)
Pro-forma net loss..................................... (0.23) (0.66)
The following represents the Company's asset retirement obligations on a
pro-forma basis as if it had adopted SFAS No. 143 as of December 31, 2002:
AS REPORTED PRO-FORMA
----------- ---------
(IN MILLIONS)
Nuclear decommissioning................................ $ 139.7 $ 186.7
Jewett lignite mine.................................... 39.7 3.8
----------- ---------
Total................................................ $ 179.4 $ 190.5
=========== =========
The Company has previously recognized removal costs as a component of
depreciation expense. Upon adoption of SFAS No. 143, the Company reversed $115
million of previously recognized removal costs as a cumulative effect of
accounting change. The total cumulative effect recognized upon adoption of SFAS
No. 143 was $99 million after-tax ($152 million pre-tax).
In April 2002, the Financial Accounting Standards Board (FASB) issued SFAS
No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections" (SFAS No. 145). SFAS No. 145
eliminates the current requirement that gains and losses on debt extinguishment
must be classified as extraordinary items in the income statement. Instead, such
gains and losses will be classified as extraordinary items only if they are
deemed to be unusual and infrequent. SFAS No. 145 also requires that capital
leases that are modified so that the resulting lease agreement is classified as
an operating lease be accounted for as a sale-leaseback transaction. The changes
related to debt extinguishment are effective for fiscal years beginning after
May 15, 2002, and the changes related to lease accounting are effective for
transactions occurring after May 15, 2002. The Company has applied this guidance
as it relates to lease accounting and the accounting provisions related to debt
extinguishment. Upon adoption of SFAS No. 145, any gain or loss on
extinguishment of debt that was classified as an extraordinary item in prior
periods is required to be reclassified. No such reclassification was required in
the three month or six month period ended June 30, 2002.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" (SFAS No. 146). SFAS No. 146
nullifies Emerging Issues Task Force (EITF) No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)" (EITF No. 94-3). The
principal difference between SFAS No. 146 and EITF No. 94-3 relates to the
requirements for recognition of a liability for costs associated with an exit or
disposal activity.
6
SFAS No. 146 requires that a liability be recognized for a cost associated with
an exit or disposal activity when it is incurred. A liability is incurred when a
transaction or event occurs that leaves an entity little or no discretion to
avoid the future transfer or use of assets to settle the liability. Under EITF
No. 94-3, a liability for an exit cost was recognized at the date of an entity's
commitment to an exit plan. In addition, SFAS No. 146 also requires that a
liability for a cost associated with an exit or disposal activity be recognized
at its fair value when it is incurred. SFAS No. 146 is effective for exit or
disposal activities that are initiated after December 31, 2002. The Company
adopted the provisions of SFAS No. 146 on January 1, 2003.
In November 2002, the FASB issued FASB Interpretation No. (FIN) 45
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others" (FIN 45). FIN 45 requires that a
liability be recorded in the guarantor's balance sheet upon issuance of certain
guarantees. In addition, FIN 45 requires disclosures about the guarantees that
an entity has issued. The provision for initial recognition and measurement of
the liability will be applied on a prospective basis to guarantees issued or
modified after December 31, 2002. The disclosure provisions of FIN 45 are
effective for financial statements of interim or annual periods ending after
December 15, 2002. The adoption of FIN 45 did not materially affect the
Company's consolidated financial statements.
In January 2003, the FASB issued FIN No. 46 "Consolidation of Variable
Interest Entities, an Interpretation of Accounting Research Bulletin No. 51"
(FIN 46). FIN 46 requires certain variable interest entities to be consolidated
by the primary beneficiary of the entity if the equity investors in the entity
do not have the characteristics of a controlling financial interest or do not
have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 is
effective for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first interim
or annual period beginning after June 15, 2003. The adoption of FIN 46 did not
materially affect the Company's consolidated financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities" (SFAS No. 149). SFAS No. 149 has
added additional criteria which were effective on July 1, 2003 for new,
acquired, or newly modified forward contracts. The Company engages in forward
contracts for the sale of power. The majority of these forward contracts are
entered into either through state mandated Texas Utility Commission auctions or
contractually mandated auctions. All of the Company's contracts resulting from
these auctions specify the product types, the plant or group of plants from
which the auctioned products are derived, the delivery location and specific
delivery requirements, and pricing for each of the products. The Company has
applied the criteria from current accounting literature, including SFAS No. 133
Implementation Issue No. C-15 - "Scope Exceptions: Normal Purchases and Normal
Sales Exception for Option-Type Contracts and Forward Contracts in Electricity",
to both the state mandated and the contractually mandated auction contracts and
believes they meet the definition of capacity contracts. Accordingly, the
Company considers these contracts as normal sales contracts rather than as
derivatives. The Company has evaluated its forward commodity contracts under the
new requirements of SFAS No. 149. The adoption of SFAS No. 149 will not change
previous accounting conclusions relating to forward power sales contracts
entered into in connection with the state mandated or contractually mandated
auctions, and will not have a material effect on the Company's financial
statements.
(3) RELATED PARTY TRANSACTIONS AND MAJOR CUSTOMERS
As of December 31, 2002, the Company had $86 million in short-term
borrowings and $19 million in long-term borrowings from CenterPoint Energy and
its subsidiaries. As of June 30, 2003, the Company had $129 million in
short-term borrowings and $19 million in long-term borrowings from CenterPoint
Energy and its subsidiaries. Such borrowings are used for working capital
purposes. Interest expense associated with the borrowings for the three months
and six months ended June 30, 2003 was $3 million and $7 million, respectively.
As of June 30, 2003, the weighted average interest rate on such borrowings was
6.14%. In addition, for the three months and six months ended June 30, 2002, $10
million and $19 million of interest expense was allocated to the Company related
to the remaining electric utility debt not specifically identified with
CenterPoint Energy's transmission and distribution utility upon deregulation.
The 1935 Act generally prohibits borrowings by CenterPoint Energy from its
subsidiaries, including the Company, either through the money pool or otherwise.
7
From time to time, the Company has receivables from, or payables to
CenterPoint Energy or its subsidiaries. As of December 31, 2002 and June 30,
2003, the Company had net accounts payable to affiliates of $23 million and $11
million, respectively.
During the three months ended June 30, 2002 and 2003, the sales and services
by the Company to Reliant Resources and its subsidiaries totaled $317 million
and $415 million, respectively. During the six months ended June 30, 2002 and
2003, the sales and services by the Company to Reliant Resources and its
subsidiaries totaled $488 million and $659 million, respectively. During the
three months ended June 30, 2002 and 2003 and the six months ended June 30,
2003, there were no sales and services by the Company to CenterPoint Energy and
its affiliates. During the six months ended June 30, 2002, the sales and
services by the Company to CenterPoint Energy and its affiliates totaled $60
million.
During the three and six months ended June 30, 2002, the sales and
services by the Company to a major customer other than Reliant Resources totaled
$47 million and $73 million, respectively. During the three and six months ended
June 30, 2003, the sales and services by the Company to a major customer other
than Reliant Resources totaled $56 million and $93 million, respectively.
During the three months ended June 30, 2002, purchases of power by the
Company from Reliant Resources were $17 million. During the six months ended
June 30, 2002, purchases of power by the Company from Reliant Resources were $24
million. During the three months ended June 30, 2002 and 2003, purchases of
natural gas by the Company from CenterPoint Energy and its affiliates were $16
million and $4 million, respectively. During the six months ended June 30, 2002
and 2003, purchases of natural gas by the Company from CenterPoint Energy and
its affiliates were $16 million and $9 million, respectively.
CenterPoint Energy provides some corporate services to the Company. The
costs of services have been directly charged to the Company using methods that
management believes are reasonable. These methods include negotiated usage
rates, dedicated asset assignment, and proportionate corporate formulas based on
assets, operating expenses and employees. These charges are not necessarily
indicative of what would have been incurred had the Company not been an
affiliate, and are included primarily in operation and maintenance expenses.
Amounts charged to the Company for these services were $12 million and $7
million for the three months ended June 30, 2002 and 2003, respectively. Amounts
charged to the Company for these services were $26 million and $17 million for
the six months ended June 30, 2002 and 2003, respectively.
(4) COMMITMENTS AND CONTINGENCIES
(a) Environmental, Legal and Other
Clean Air Standards. The Texas electric restructuring law and regulations
adopted by the Texas Commission on Environmental Quality in 2001 require
substantial reductions in emission of oxides of nitrogen (NOx) from electric
generating units. The Company is currently installing cost-effective controls at
its generating plants to comply with these requirements. Through June 30, 2003,
the Company has invested $610 million for NOx emission control, and plans to
make expenditures of up to approximately $181 million for the remainder of 2003
through 2007. The Texas Utility Commission has determined that the Company's
emission control plan is the most cost-effective option for achieving compliance
with applicable air quality standards for the Company's generating facilities.
Nuclear Insurance. The Company and the other owners of the South Texas
Project maintain nuclear property and nuclear liability insurance coverage as
required by law and periodically review available limits and coverage for
additional protection. The owners of the South Texas Project currently maintain
$2.75 billion in property damage insurance coverage, which is above the legally
required minimum, but is less than the total amount of insurance currently
available for such losses.
8
Under the Price Anderson Act, the maximum liability to the public of owners
of nuclear power plants was $9.3 billion as of June 30, 2003. Owners are
required under the Price Anderson Act to insure their liability for nuclear
incidents and protective evacuations. The Company and the other owners currently
maintain the required nuclear liability insurance and participate in the
industry retrospective rating plan under which the owners of the South Texas
Project are subject to maximum retrospective assessments in the aggregate per
incident of up to $88 million per reactor. The owners are jointly and severally
liable at a rate not to exceed $10 million per incident per year. In addition,
the security procedures at this facility have recently been enhanced to provide
additional protection against terrorist attacks.
There can be no assurance that all potential losses or liabilities
associated with the South Texas Project will be insurable, or that the amount of
insurance will be sufficient to cover them. Any substantial losses not covered
by insurance would have a material effect on the Company's financial condition,
results of operations and cash flows.
Nuclear Decommissioning. The Company contributed $2.9 million in 2002 to
trusts established to fund its share of the decommissioning costs for the South
Texas Project, and expects to contribute $2.9 million in 2003. There are various
investment restrictions imposed upon the Company by the Texas Utility Commission
and the United States Nuclear Regulatory Commission (NRC) relating to the
Company's nuclear decommissioning trusts. The Company and CenterPoint Energy
have each appointed two members to the Nuclear Decommissioning Trust Investment
Committee which establishes the investment policy of the trusts and oversees the
investment of the trusts' assets. The securities held by the trusts for
decommissioning costs had an estimated fair value of $174 million as of June 30,
2003, of which approximately 40% were fixed-rate debt securities and the
remaining 60% were equity securities. In July 1999, an outside consultant
estimated the Company's portion of decommissioning costs to be approximately
$363 million. While the funding levels currently exceed minimum NRC
requirements, no assurance can be given that the amounts held in trust will be
adequate to cover the actual decommissioning costs of the South Texas Project.
Such costs may vary because of changes in the assumed date of decommissioning
and changes in regulatory requirements, technology and costs of labor, materials
and equipment. Pursuant to the Texas electric restructuring law, costs
associated with nuclear decommissioning that have not been recovered as of
January 1, 2002, will continue to be subject to cost-of-service rate regulation
and will be included in a charge to transmission and distribution customers.
CenterPoint Energy is contractually obligated to indemnify the Company from and
against any obligations relating to the decommissioning not otherwise satisfied
through collections by CenterPoint Houston.
Joint Operating Agreement with City of San Antonio. The Company has a joint
operating agreement with the City Public Service Board of San Antonio to share
savings from the joint dispatching of each party's generating assets.
Dispatching the two generating systems jointly results in savings of fuel and
related expenses because there is a more efficient utilization of each party's
lowest cost resources. The two parties equally share the savings resulting from
joint dispatch. The agreement terminates in 2009.
Supplier Suits. The Company is currently engaged in a dispute with its fuel
supplier at its Limestone electric generation facility over the terms and
pricing for fuel supplied to that facility under a 1999 settlement agreement
between the parties and under ancillary obligations. The Company has filed suit
for a declaratory judgment and damages against the supplier, Northwestern
Resources Co. (NWR), in Harris County, Texas, and NWR has filed an amended
petition seeking a declaratory judgment in an action previously filed against
Reliant Energy in Limestone County, Texas. NWR claims the Company has breached
its obligations by modifying its generation facility to burn coal from the
Powder River Basin and by purchasing coal from the Powder River Basin without
first giving NWR a right of first refusal to supply lignite at a price that is
equal to or less than the coal from the Powder River Basin. NWR also contends
that the Company is not entitled to certain production royalties. In its suit,
the Company seeks rulings that it has not breached its obligations regarding the
modification of its facilities and the burning of Powder River Basin coal but
that, instead, NWR has breached its obligations by failing to pay production
royalties and in other respects.
(b) Option to Purchase CenterPoint Energy's Interest in the Company
Reliant Resources has an option (Reliant Resources Option) to purchase all
of the shares of common stock of the Company owned by CenterPoint Energy.
Reliant Resources has no obligation to exercise the option. The Reliant
Resources Option may be exercised between January 10, 2004 and January 24, 2004.
The per share exercise price under the Reliant Resources Option will equal the
average daily closing price on The New York Stock Exchange for
9
the 30 consecutive trading days with the highest average closing price for any
30 day trading period during the last 120 trading days ending January 9, 2004,
plus a control premium, up to a maximum of 10%, to the extent a control premium
is included in the valuation determination made by the Texas Utility Commission
relating to the market value of the Company. The per share exercise price is
also subject to adjustment based on the difference between the per share
dividends paid to CenterPoint Energy during the period from January 6, 2003
through the option closing date and the Company's actual per share earnings
during that period. Reliant Resources has agreed that if it exercises the
Reliant Resources Option and purchases the shares of the Company's common stock,
Reliant Resources will also purchase from CenterPoint Energy all notes and other
payables owed by the Company to CenterPoint Energy as of the option closing
date, at their principal amount plus accrued interest. Similarly, if there are
notes or payables owed to the Company by CenterPoint Energy as of the option
closing date, Reliant Resources will assume those obligations in exchange for a
payment from CenterPoint Energy of an amount equal to the principal plus accrued
interest.
In the event that Reliant Resources exercises the Reliant Resources Option
in 2004, the Company would be required to step-up or step-down the tax basis in
all of its assets following the date of the sale to be equivalent generally to
the value of the equity of the Company (based upon the purchase price) plus the
principal amount of the Company's indebtedness at the time of the purchase. The
resulting step-up or step-down in the basis of the Company's assets would impact
its future tax liabilities. A step-up would reduce the Company's future tax
liabilities, while a step-down would increase its liabilities. The Company
cannot currently project the impact of this tax election because it is dependent
on (1) Reliant Resources' exercise of its option in 2004, and (2) the purchase
price to be paid by Reliant Resources in 2004, which is not known at this time.
Exercise of the Reliant Resources Option by Reliant Resources will be
subject to various regulatory approvals, including Hart-Scott-Rodino antitrust
clearance, in certain circumstances, approval of the SEC under the 1935 Act and
United States Nuclear Regulatory Commission (NRC) license transfer approval.
(5) SUBSEQUENT EVENTS
(a) W.A. Parish Facility
On July 15, 2003, a steam line ruptured at the Company's W.A. Parish coal
facility damaging one of the facility's units and temporarily taking another
unit offline. The Company anticipates that the unit will be out of service
through September 2003. A thorough root cause analysis process is underway and a
detailed repair plan is being implemented. An estimated cost for damage repair
is being developed.
(b) Declaration of Dividend
On August 7, 2003, the Company's board of directors declared a dividend of
$0.25 per share of common stock payable September 19, 2003 to shareholders of
record as of the close of business on August 26, 2003.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The following discussion and analysis should be read in combination with the
Company's Interim Financial Statements and notes contained in Item 1 of this
report.
OVERVIEW
We are one of the largest wholesale electric power generating companies in
the United States. As of June 30, 2003, the aggregate net generating capacity of
our portfolio of assets was 14,175 megawatts (MW). We sell electric generation
capacity, energy and ancillary services in the Electric Reliability Council of
Texas (ERCOT) market, which is the largest power market in the State of Texas.
The ERCOT market consists of the majority of the population centers in the State
of Texas and facilitates reliable grid operations for approximately 85% of the
demand for power in the state.
OUR SEPARATION FROM CENTERPOINT ENERGY
Legislation enacted by the Texas legislature in 1999 (Texas electric
restructuring law) required the restructuring of electric utilities in Texas in
order to separate their power generation, transmission and distribution, and
retail electric provider businesses into separate units. In March 2001, the
Public Utility Commission of Texas (Texas Utility Commission) approved a
business separation plan for Reliant Energy, Incorporated (Reliant Energy)
involving the separation of Reliant Energy's generation, transmission and
distribution, and retail businesses into three separate companies. Effective
August 31, 2002, Reliant Energy consummated a restructuring transaction (the
Restructuring) in accordance with its business separation plan in which it,
among other things:
- conveyed all of its electric generating facilities to us;
- became a subsidiary of CenterPoint Energy, Inc. (CenterPoint Energy);
and
- converted into a limited liability company named CenterPoint Energy
Houston Electric, LLC (CenterPoint Houston).
Although our portfolio of generating facilities was formerly owned by the
unincorporated electric utility division of Reliant Energy, for convenience we
describe our business as if we had owned and operated our generation facilities
prior to the date they were conveyed to us. The book value of the net assets
conveyed to us by Reliant Energy on August 31, 2002 was approximately $2.8
billion.
CenterPoint Energy is a registered public utility holding company under the
Public Utility Holding Company Act of 1935, as amended (1935 Act). The 1935 Act
and related rules and regulations impose a number of restrictions on the
activities of CenterPoint Energy and its subsidiaries. The 1935 Act, among other
things, limits the ability of the holding company and its subsidiaries to issue
debt and equity securities without prior authorization, restricts the source of
dividend payments to funds from current and retained earnings without prior
authorization, regulates sales and acquisitions of certain assets and businesses
and governs affiliate transactions. CenterPoint Energy and its subsidiaries,
including us, received an order from the Securities and Exchange Commission
(SEC) under the 1935 Act on June 30, 2003 (June 2003 Financing Order) relating
to financing and other activities, which is effective until June 30, 2005.
On January 6, 2003, CenterPoint Energy distributed approximately 19% of the
80 million outstanding shares of our common stock to CenterPoint Energy's
shareholders (the Distribution). As used herein, CenterPoint Energy also refers
to the former Reliant Energy for dates prior to the Restructuring.
Our energy costs consist primarily of our fuel costs associated with
consuming nuclear fuel, gas, oil, lignite and coal to generate energy, as well
as our power purchases from the wholesale marketplace. The recent deregulation
of the ERCOT market has impacted our energy costs in several ways. As a result
of requirements under the Texas electric restructuring law and the terms of our
agreements with CenterPoint Energy, we are obligated to sell substantially all
of our available capacity and related ancillary services through 2003. In these
auctions, we sell on a forward basis firm entitlements to capacity and ancillary
services dispatched within specified operational constraints. Although we have
reserved a portion of our aggregate net generation capacity from our capacity
11
auctions for planned or forced outages at our facilities, unanticipated plant
outages or other problems with our generation facilities could result in our
firm capacity and ancillary services commitments exceeding our available
generation capacity. As a result, we could be required to obtain replacement
power from third parties in the open market to satisfy our firm commitments
which could involve the incurrence of significant additional costs. In addition,
an unexpected outage at one of our lower cost facilities could require us to run
one of our higher cost plants in order to satisfy our obligations. High
wholesale power prices for replacement power in the ERCOT market could increase
our energy costs and affect earnings and net cash flow.
In 2002, our capacity auctions were consummated at market-based prices that
resulted in returns substantially below the historical regulated return on our
facilities that we have experienced in the past. However, we have seen
significant improvement in auction prices for our 2003 capacity entitlements.
Since the pricing of our generation products is sensitive to natural gas prices,
higher natural gas prices in the latter part of 2002 and in the first half of
2003 have positively influenced the prices in our recent capacity auctions.
Because we have a significant amount of low-cost base-load solid fuel and
nuclear generating units, higher natural gas prices generally increase the
margin of our base-load capacity entitlements since prospective purchasers face
higher-cost gas-fired generation alternatives. With the higher market prices and
our efforts to reduce our operating costs, we expect to show an improvement in
profitability for 2003. However, we do not expect this improvement will reach
the levels of our historical regulated returns in the near future due in part to
the current surplus of generating capacity in the ERCOT market and changes to
the economic conditions affecting our industry that have occurred since our
base-load facilities were originally constructed, including the development of
high efficiency gas-fired generating units.
In the capacity auctions held during January through July 2003, gas
generation capacity only sold in our contractually mandated auctions. We will
continue to have P.H. Robinson Unit 3 and Webster Unit 3, both totaling 926 MW,
in mothball status through November 2003. We are evaluating the July auction
results and determining the need for additional generating capacity to be placed
in mothball status for the remaining months of 2003.
Additional generating units are expected to come on line in ERCOT in the
future. With an increasingly competitive wholesale energy market, the
composition and level of our operation and maintenance expense is likely to
change.
RECENT DEVELOPMENTS
On July 15, 2003, a steam line ruptured at our W.A. Parish coal facility
damaging one of the facility's units and temporarily taking another unit
offline. We anticipate that the unit will be out of service through September
2003. A thorough root cause analysis process is underway and a detailed repair
plan is being implemented. An estimated cost for damage repair is being
developed.
During a routine refueling and maintenance outage in early April 2003,
engineers found a small quantity of residue from reactor cooling water in the
South Texas Project Electric Generating Station (South Texas Project) Unit 1
reactor containment building. Upon discovery of the residue, South Texas Project
officials immediately reported their findings to the Nuclear Regulatory
Commission (NRC). The South Texas Project staff completed repairs on South Texas
Project Unit 1 and the unit was returned to operation on August 9, 2003
following NRC approval.
12
CONSOLIDATED RESULTS OF OPERATIONS
For information regarding factors that may affect the future results of
operations of our business, please read "Risk Factors" in Item 5 of Part II of
this report, which is incorporated herein by reference. The following table sets
forth our consolidated results of operations for the three months and six months
ended June 30, 2002 and 2003, followed by a discussion of our consolidated
results of operations.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
---------------------------------- -------------------------------
2002 2003 2002 2003
--------------- ------------- ------------- -------------
REVENUES:
Energy revenues.............................. $ 306,327 $ 378,402 $ 546,809 $ 602,166
Capacity and other revenues.................. 107,321 200,109 192,486 334,932
--------------- ------------- ------------- -------------
Total................................... 413,648 578,511 739,295 937,098
--------------- ------------- ------------- -------------
EXPENSES:
Fuel costs................................... 295,241 349,318 476,224 557,307
Purchased power.............................. 4,258 22,974 52,624 34,968
Operation and maintenance.................... 78,906 105,301 173,615 210,651
Depreciation and amortization................ 38,601 39,391 78,932 78,470
Taxes other than income taxes................ 25,764 11,483 38,778 22,774
--------------- ------------- ------------- -------------
Total................................... 442,770 528,467 820,173 904,170
--------------- ------------- ------------- -------------
OPERATING INCOME (LOSS)........................ (29,122) 50,044 (80,878) 32,928
OTHER INCOME................................... 2,902 1,089 2,904 1,289
INTEREST EXPENSE, NET.......................... 7,962 2,822 15,951 5,625
--------------- ------------- ------------- -------------
INCOME (LOSS) BEFORE INCOME TAXES AND
CUMULATIVE EFFECT OF ACCOUNTING CHANGE..... (34,182) 48,311 (93,925) 28,592
INCOME TAX BENEFIT (EXPENSE)................... 15,890 (15,018) 40,939 (6,181)
--------------- ------------- ------------- -------------
INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF
ACCOUNTING CHANGE............................ (18,292) 33,293 (52,986) 22,411
CUMULATIVE EFFECT OF ACCOUNTING CHANGE, NET OF
TAX.......................................... -- -- -- 98,910
--------------- ------------- ------------- -------------
NET INCOME (LOSS).............................. $ (18,292) $ 33,293 $ (52,986) $ 121,321
=============== ============= ============= =============
BASIC AND DILUTED EARNINGS PER SHARE:
Income (Loss) Before Cumulative Effect of
Accounting Change......................... $ (0.23) $ 0.42 $ (0.66) $ 0.28
Cumulative Effect of Accounting Change, net
of tax.................................... -- -- -- 1.24
--------------- ------------- ------------- -------------
Net Income (Loss)........................... $ (0.23) $ 0.42 $ (0.66) $ 1.52
=============== ============= ============= =============
THREE MONTHS ENDED JUNE 30, 2003 COMPARED TO THREE MONTHS ENDED JUNE 30, 2002
We reported net income of $33 million ($0.42 per diluted share) for the
three months ended June 30, 2003 compared to a loss of $18 million ($0.23 per
diluted share) for the three months ended June 30, 2002. The $51 million
improvement was primarily attributable to increased margins from higher capacity
and energy revenues as a result of higher capacity auction prices driven by
higher natural gas prices, offset by increased fuel costs due to higher natural
gas prices and purchased power costs. Due to the operating flexibility of some
of the gas units, we were able to partially mitigate the higher cost of natural
gas by switching from natural gas to fuel oil.
Operation and maintenance expense increased $26 million for the three
months ended June 30, 2003 as compared to the same period in 2002. Approximately
$6 million was associated with higher pension and employee benefits, $6 million
with scheduled plant outages, $4 million with repairs to South Texas Project
Unit 1 and $5 million associated with the timing of technical support costs.
Taxes other than income taxes decreased $14 million for the three months
ended June 30, 2003 as compared to the same period in 2002. This decrease was
primarily attributable to a reduction in state franchise taxes which are no
longer applicable in 2003.
13
Interest expense, net decreased $5 million, or 65%, for the three months
ended June 30, 2003 from the comparable 2002 period primarily as a result of $10
million in intercompany interest allocated in 2002 prior to the Restructuring
and related to the remaining electric utility debt not specifically identified
with CenterPoint Energy's transmission and distribution utility upon
deregulation. This decrease was partially offset by interest expense of $3
million on intercompany borrowings from CenterPoint Energy to fund working
capital requirements in the second quarter of 2003.
The effective tax rates for the three months ended June 30, 2003 and 2002
were 31.1% and 46.5%, respectively. The decrease in the effective rate for the
three months ended June 30, 2003 compared to the three months ended June 30,
2002 was primarily the result of a decrease in pre-tax income in 2003 compared
to a pre-tax loss in 2002, offset by reduced benefits from state taxes and the
amortization of investment tax credits.
SIX MONTHS ENDED JUNE 30, 2003 COMPARED TO SIX MONTHS ENDED JUNE 30, 2002
We reported income before cumulative effect of accounting change of $22
million ($0.28 per diluted share) for the six months ended June 30, 2003
compared to a loss of $53 million ($0.66 per diluted share) for the six months
ended June 30, 2002. The $75 million improvement was primarily attributable to
increased margins from higher capacity and energy revenues as a result of higher
capacity auction prices driven by higher natural gas prices, offset by increased
fuel costs due to higher natural gas prices and purchased power costs. Due to
the operating flexibility of some of the gas units, we were able to partially
mitigate the higher cost of natural gas by switching from natural gas to fuel
oil.
Operation and maintenance expense increased $37 million for the six months
ended June 30, 2003 as compared to the same period in 2002. The increase was
primarily due to repairs on South Texas Project Unit 1 ($4 million), an
unplanned outage on South Texas Project Unit 2 ($4 million), a planned refueling
outage on South Texas Project Unit 1 without a comparable outage in 2002 ($6
million), higher pension and benefit expenses ($4 million), timing of technical
support expenses ($9 million) and increased insurance and other expenses ($7
million).
Taxes other than income taxes decreased $16 million for the six months
ended June 30, 2003 as compared to the same period in 2002. This decrease was
primarily attributable to a reduction in state franchise taxes that are no
longer applicable in 2003 and a reduction in property taxes due to lower
valuations.
Interest expense, net decreased $10 million, or 65%, for the six months
ended June 30, 2003 from the comparable 2002 period primarily as a result of $19
million in intercompany interest allocated in 2002 prior to the Restructuring
and related to the remaining electric utility debt not specifically identified
with CenterPoint Energy's transmission and distribution utility upon
deregulation. This decrease was partially offset by interest expense of $5.6
million on intercompany borrowings from CenterPoint Energy to fund working
capital requirements in the first six months of 2003.
The effective tax rates for the six months ended June 30, 2003 and 2002
were 21.6% and 43.6%, respectively. The decrease in the effective rate for the
six months ended June 30, 2003 compared to the six months ended June 30, 2002
was primarily the result of a pre-tax income in 2003 compared to a pre-tax loss
in 2002, offset by reduced benefits from state taxes and the amortization of
investment tax credits.
In connection with the adoption of Statement of Financial Accounting
Standards (SFAS) No. 143, "Accounting for Asset Retirement Obligations" (SFAS
No. 143), we have completed an assessment of the applicability and implications
of SFAS No. 143. As a result of the assessment, we have identified retirement
obligations for nuclear decommissioning at the South Texas Project and for
lignite mine operations at the Jewett mine supplying the Limestone electric
generation facility. The net difference between the amounts determined under
SFAS No. 143 and the previous method of accounting for estimated mine
reclamation costs was $37 million and has been recorded as a cumulative effect
of accounting change. Upon adoption of SFAS No. 143, we reversed $115 million of
previously recognized removal costs as a cumulative effect of accounting change.
Our operating results for the six months ended June 30, 2003 results include a
$99 million after-tax ($152 million pre-tax) non-cash gain ($1.24 per diluted
share) from the adoption of SFAS No. 143. For additional discussion of the
adoption of SFAS No. 143, please read Note 2 to our Interim Financial
Statements.
14
RELATED PARTY TRANSACTIONS
OUR RELATIONSHIPS WITH CENTERPOINT ENERGY
Separation Agreement. In connection with the Distribution, we entered into
a separation agreement with CenterPoint Energy. This agreement contains
provisions governing our relationship with CenterPoint Energy following the
Distribution and specifies the related ancillary agreements between us and
CenterPoint Energy. In addition, the separation agreement provides for
cross-indemnities generally intended to place sole financial responsibility on
us and our subsidiaries for all liabilities associated with the current and
historical business and operations we conduct, regardless of the time those
liabilities arose, and to place sole financial responsibility for liabilities
associated with CenterPoint Energy's other businesses with CenterPoint Energy
and its other subsidiaries. The separation agreement also contains
indemnification provisions under which we and CenterPoint Energy each indemnify
the other with respect to breaches by the indemnifying party of the separation
agreement or any ancillary agreements.
Transition Services Agreement. We have entered into a transition services
agreement with CenterPoint Energy under which CenterPoint Energy will provide us
through the earlier of such time as all services under the agreement are
terminated or CenterPoint Energy ceases to own a majority of our common stock,
various corporate support services that include accounting, finance, investor
relations, planning, legal, communications, governmental and regulatory affairs
and human resources, as well as information technology services and other
previously shared services such as corporate security, facilities management,
accounts receivable, accounts payable and payroll, office support services and
purchasing and logistics. These services consist generally of the same types of
services as have been provided on an intercompany basis prior to this
distribution. The charges we pay for the services are on a basis generally
intended to allow CenterPoint Energy to recover the fully allocated direct and
indirect costs of providing the services, plus all out-of-pocket costs and
expenses, but without any profit to CenterPoint Energy, except to the extent
routinely included in traditional utility cost of capital. Pursuant to a
separate lease agreement, CenterPoint Energy has agreed to lease office space in
its principal office building in Houston, Texas to us for an interim period
expected to end no later than December 31, 2004.
Tax Allocation Agreement. We are members of the CenterPoint Energy
consolidated group for tax purposes, and we will continue to file a consolidated
federal income tax return with CenterPoint Energy while CenterPoint Energy
retains its 81% interest in us. Accordingly, we have entered into a tax
allocation agreement with CenterPoint Energy to govern the allocation of U.S.
income tax liabilities and to set forth agreements with respect to certain other
tax matters. CenterPoint Energy will be responsible for preparing and filing any
U.S. income tax returns required to be filed for any company or group of
companies of the CenterPoint Energy consolidated group, including all tax
returns for us for so long as we are members of the CenterPoint Energy
consolidated group. CenterPoint Energy will also be responsible for paying the
taxes related to the returns it is responsible for filing. We will be
responsible for paying CenterPoint Energy our allocable share of such taxes.
CenterPoint Energy will determine all tax elections for tax periods during which
we are a member of the CenterPoint Energy consolidated group. Generally, if
there are tax adjustments related to us which relate to a tax return filed for a
period when we were a member of the CenterPoint Energy consolidated group, we
will be responsible for any increased taxes and we will receive the benefit of
any tax refunds.
Employee Benefit Plans. Our eligible employees currently participate in
CenterPoint Energy's employee benefit plans and programs in accordance with the
terms and conditions of such plans and programs, as may be amended or terminated
by CenterPoint Energy at any time. Additionally, CenterPoint Energy expects that
a separate pension plan will be established for us in 2004. We would receive an
allocation of assets from the CenterPoint Energy pension plan pursuant to rules
and regulations under the Employee Retirement Income Security Act of 1974 and
record its pension obligations in accordance with SFAS No. 87, "Employer's
Accounting for Pensions." It is anticipated that a plan established for us will
be underfunded and that such underfunding could be significant. Changes in
interest rates and the market values of the securities held by the CenterPoint
Energy pension plan during 2003 could materially, positively or negatively,
change the funding status of a plan established for us.
RELIANT RESOURCES OPTION
As part of Reliant Energy's business separation plan, Reliant Resources,
Inc. (Reliant Resources) was granted an option that may be exercised between
January 10, 2004 and January 24, 2004 to purchase all of the approximately 81%
of the outstanding shares of our common stock currently owned by CenterPoint
Energy (Reliant Resources
15
Option). The terms of the option agreement were amended in February 2003. The
per share exercise price under the Reliant Resources Option will equal the
average daily closing price of our common stock on The New York Stock Exchange
over the 30 consecutive trading days out of the last 120 trading days ending
January 9, 2004 which result in the highest average closing price. In addition,
a control premium, up to a maximum of 10%, will be added to the price to the
extent a control premium is included in the valuation determination made by the
Texas Utility Commission relating to our market value. If the option closing has
not occurred within sixteen months of the option exercise, rights under the
option agreement will terminate. Reliant Resources will be entitled to rescind
its exercise of the option by giving notice to CenterPoint Energy on or before
the 45th day following the option exercise date if Reliant Resources has been
unable by that date to secure financing for its purchase of the shares of our
common stock on terms reasonably acceptable to Reliant Resources. Upon the
giving of such notice of rescission, the option period will be deemed to have
expired without exercise of the option.
The exercise price formula is based upon the generation asset valuation
methodology in the Texas electric restructuring law that CenterPoint Houston
will use to calculate our market value. The exercise price is also subject to
adjustment based on the difference between the per share dividends we pay to
CenterPoint Energy during the period from January 6, 2003 through the option
closing date and our actual per share earnings during that period. To the extent
our per share dividends are less than our actual per share earnings during that
period, the per share option price will be increased. To the extent our per
share dividends exceed our actual per share earnings, the per share option price
will be reduced.
Reliant Resources has agreed that if it exercises its option, Reliant
Resources will purchase from CenterPoint Energy all notes and other payables
owed by us to CenterPoint Energy as of the option closing date, at their
principal amount plus accrued interest. Similarly, if there are notes or
payables owed to us by CenterPoint Energy as of the option closing date, Reliant
Resources will assume those obligations in exchange for a payment from
CenterPoint Energy of an amount equal to the principal plus accrued interest.
In the event Reliant Resources exercises its option, we would be required to
step-up or step-down the tax basis in all of our assets following the date of
the sale to be equivalent generally to the value of the our equity, based upon
the purchase price, plus the principal amount of our indebtedness at the time of
the purchase.
In connection with the Reliant Resources Option, we are obligated to operate
and maintain our assets and otherwise conduct our business in the ordinary
course in a manner consistent with past practice and to make expenditures for
operations, maintenance, repair and capital expenditures necessary to keep our
assets in good condition and in compliance with applicable laws, in a manner
consistent with good electric generation industry practice. We are also required
to maintain customary levels of insurance, comply with laws and contractual
obligations and pay taxes when due. We may not permanently retire generation
units, but may "mothball" units if economically warranted.
Under an agreement with Reliant Resources, CenterPoint Energy has agreed to
maintain ownership of its approximate 81% interest in us following the
Distribution until exercise or expiration of the Reliant Resources Option.
Reliant Resources has granted a waiver that would permit CenterPoint Energy to
grant a security interest in its 81% interest in us to CenterPoint Energy's
creditors. CenterPoint Energy has granted such a security interest to lenders
under a bank loan agreement maturing in 2005. In addition, we have agreed that
we will not issue additional equity securities. CenterPoint Energy has agreed to
lend funds to us for operating needs upon request from time to time following
the Distribution. We may also obtain third-party financing if we so desire. Our
agreements with CenterPoint Energy contain covenants restricting our ability to:
- merge or consolidate with another entity;
- sell assets;
- enter into long-term agreements and commitments for the purchase of
fuel or the purchase or sale of power outside the ordinary course of
business;
- engage in other businesses;
- construct or acquire new generation plants or capacity;
16
- engage in hedging transactions;
- encumber our assets;
- issue additional equity securities;
- pay special dividends; and
- make certain loans, investments or advances to, or engage in certain
transactions with, our affiliates.
Exercise of the Reliant Resources Option will be subject to various
regulatory approvals, including Hart-Scott-Rodino antitrust clearance, in
certain circumstances, approval of the SEC under the 1935 Act and NRC license
transfer approval. In certain circumstances involving a change in control of us,
the time at which the Reliant Resources Option may be exercised and the period
over which the exercise price is determined are accelerated, with corresponding
changes to the time and manner of payment of the exercise price.
Should Reliant Resources decline to exercise its option, CenterPoint Energy
has indicated that it intends to explore other alternatives to monetize its 81%
ownership interest in us, including possible sale of its ownership interest in
us or of our individual generating assets.
For a description of the limitations on our ability to pay dividends, please
read "Market for Common Stock and Related Stockholder Matters" in Item 5 of the
Texas Genco Form 10-K, which is incorporated by reference herein.
TECHNICAL SERVICES AGREEMENT WITH RELIANT RESOURCES
Under a technical services agreement, Reliant Resources is obligated to
provide engineering and technical support services and environmental, safety and
industrial health services to support the operation and maintenance of our
facilities. Reliant Resources is also obligated to provide systems, technical,
programming and consulting support services and hardware maintenance (but
excluding plant-specific hardware) necessary to provide dispatch planning,
dispatch, and settlement and communication with the ERCOT independent system
operator, as well as general information technology services for us. The fees
Reliant Resources charges for these services are designed to allow it to recover
its fully allocated direct and indirect costs and to obtain reimbursement of all
out-of-pocket expenses. Expenses associated with capital investment in systems
and software that benefit both the operation of Reliant Resources' facilities
and our facilities will be allocated on an installed MW basis.
The technical services agreement will terminate on the first to occur of:
- the closing date on which Reliant Resources acquires our shares from
CenterPoint Energy, if the Reliant Resources Option is exercised;
- CenterPoint Energy's sale of us, or all or substantially all of our
assets, if the Reliant Resources Option is not exercised; or
- May 31, 2005, provided that if the Reliant Resources Option is not
exercised, we may extend the term of this agreement until December 31,
2005.
17
CAPACITY AUCTIONS
Through 2003, Reliant Resources has the contractual right, but not the
obligation, to purchase 50% (but not less than 50%) of each type of capacity
entitlement we auction in our contractually mandated auctions at the prices
established in the auctions. To exercise this right, Reliant Resources is
required to notify us whether it elects to purchase 50% of the capacity
auctioned no later than three business days prior to the date of the auction. We
exclude the amount of capacity specified in Reliant Resources' notice from the
auction. We auction any portion of the capacity that Reliant Resources does not
reserve through its notice with the balance of the capacity we auction in the
contractually mandated auctions.
Upon determination of the auction prices for the capacity entitlements we
auction, Reliant Resources is obligated to purchase the capacity it elected to
reserve from the auction process at the prices set during the auction for that
entitlement. If we auction capacity and ancillary services separately, Reliant
Resources is entitled to participate in 50% of the offered capacity of each. In
addition to its reservation of capacity, and whether or not it has reserved
capacity in the auction, Reliant Resources is entitled to participate in each
contractually mandated auction. If Reliant Resources exercises the Reliant
Resources Option, we will not conduct any capacity auctions, other than as
required by Texas Utility Commission rules, between the option exercise date and
the option closing date without obtaining Reliant Resources' consent, which it
may not unreasonably withhold. If Reliant Resources does not exercise its
option, we will cease to be required to conduct contractually mandated auctions
following the option exercise period.
We sold 91% of our available capacity for 2002 and through July 2003 have
sold 91% of our available capacity for 2003. Reliant Resources purchased
entitlements to 63% of the available 2002 capacity and through July 2003 has
purchased 71% of the available 2003 capacity. These purchases were made either
through the exercise by Reliant Resources of its contractual rights to purchase
50% of the entitlements auctioned in the contractually mandated auctions or
through the submission of bids in those auctions. In either case, these
purchases were made at market-based prices. We have also sold forward some of
our baseload capacity for 2004 and 2005. In May 2003, we sold 22% of our 2004
available baseload capacity and 9% of our 2005 available baseload capacity. In
July 2003, we sold like amounts of capacity, bringing the total available
baseload capacity sold forward to 43% for 2004 and 18% for 2005. We have been
granted a security interest in accounts receivable and/or notes associated with
the accounts receivable of certain subsidiaries of Reliant Resources to secure
up to $250 million in purchase obligations.
SOUTH TEXAS PROJECT DECOMMISSIONING TRUST
We are the beneficiary of the decommissioning trust that has been
established to provide funding for decontamination and decommissioning of the
South Texas Project in which we own a 30.8% interest. CenterPoint Houston
collects, through rates or other authorized charges to its electric utility
customers, amounts designated for funding the decommissioning trust, and
deposits these amounts into the decommissioning trust. Upon decommissioning of
the facility, in the event funds from the trust are inadequate, CenterPoint
Houston or its successor will be required to collect through rates to customers
as contemplated by the Texas Utilities Code all additional amounts required to
fund our obligations relating to the decommissioning of the facility. Following
the completion of the decommissioning, if surplus funds remain in the
decommissioning trust, the excess will be refunded to the ratepayers of
CenterPoint Houston or its successor.
COMMON DIRECTORS
David M. McClanahan, Gary L. Whitlock and Scott E. Rozzell are directors
and/or officers of CenterPoint Energy. As a result, they may need to recuse
themselves and not participate in board meetings where actions are taken in
connection with transactions or other relationships involving both companies.
18
CERTAIN FACTORS AFFECTING FUTURE EARNINGS
For information on other developments, factors and trends that may have an
impact on our future earnings, please read "Management's Discussion and Analysis
of Financial Condition and Results of Operations - Certain Factors Affecting
Future Earnings" in the Texas Genco Form 10-K and "Risk Factors" in Item 5 of
Part II of this report, each of which is incorporated herein by reference.
In addition to these factors, please read the discussion of the South Texas
Project Unit 1 and W.A. Parish facility forced outages under "-- Recent
Developments."
LIQUIDITY AND CAPITAL RESOURCES
HISTORICAL CASH FLOWS
The net cash provided by/used in our operating, investing and financing
activities for the six months ended June 30, 2002 and 2003 is as follows (in
millions):
SIX MONTHS ENDED JUNE 30,
-------------------------
2002 2003
-------- --------
Cash provided by (used in):
Operating activities............................. $ (149) $ 72
Investing activities............................. (143) (75)
Financing activities............................. 292 2
CASH PROVIDED BY OPERATING ACTIVITIES
Net cash provided by operating activities for the six months ended June 30,
2003 increased $221 million as compared to the same period in 2002. This
increase was primarily due to increased earnings as a result of higher capacity
auction prices, which are driven by higher gas prices, and increased accounts
payable. Additionally, in the first quarter of 2002, the Company paid higher
taxes associated with regulated revenues for 2001. These increases were
partially offset by an increase in inventory primarily related to timing of
deliveries in late 2001 and higher gas prices in 2003.
CASH USED IN INVESTING ACTIVITIES
Net cash used in investing activities for the six months ended June 30,
2003 decreased $68 million as compared to the same period in 2002 primarily due
to the completion of a major portion of the required environmental capital
expenditures for emissions of oxides of nitrogen (NOx) during 2002.
CASH PROVIDED BY FINANCING ACTIVITIES
Net cash provided by financing activities for the six months ended June 30,
2003 decreased $290 million as compared to the same period in 2002. The decrease
was primarily a result of reductions in transfers from CenterPoint Energy to
support various requirements for working capital and capital expenditures,
partially offset by a dividend on our common stock in the first and second
quarters of 2003.
FUTURE SOURCES AND USES OF CASH
We expect to meet our future capital requirements with cash flows from
operations, as well as a combination of intercompany loans from our affiliates
and external financing as necessary. From time to time we may use the proceeds
of our third party borrowings to repay intercompany indebtedness, make dividend
payments or for other corporate purposes. We have obtained consent from Reliant
Resources to grant security interests in our assets to lenders under third party
facilities. We believe that our cash flows from operations, intercompany loans
from our affiliates and our borrowing capability will be sufficient to meet the
operational needs of our business for the next twelve months.
19
In February 2003, CenterPoint Energy reached an agreement with a syndicate
of banks on a second amendment to its bank facility. Under the terms of the
amended bank facility, CenterPoint Energy agreed with the banks not to permit us
to incur indebtedness for borrowed money in an aggregate principal amount at any
one time outstanding in excess of $250 million. In addition, CenterPoint Energy
agreed that proceeds from the sale of any material portion of our assets,
subject to certain requirements, or our incurrence of indebtedness for borrowed
money in excess of specified levels would be used to prepay outstanding
indebtedness under CenterPoint Energy's bank facility. Although we are not
contractually bound by these limitations, CenterPoint Energy would likely cause
its representatives on our board of directors to direct our business so as not
to breach the terms of the agreement.
The June 2003 Financing Order limits the amount of external debt and equity
securities that we can issue without additional authorization and permits
refinancing. We are in compliance with these limits. Under the June 2003
Financing Order, we are permitted to issue an incremental aggregate $250 million
of debt.
The June 2003 Financing Order requires that if we issue any securities that
are rated by a nationally recognized statistical rating organization (NRSRO),
the security to be issued must obtain an investment grade rating from at least
one NRSRO and, as a condition to such issuance, all outstanding rated securities
of ours and of CenterPoint Energy must be so rated by at least one NRSRO. The
June 2003 Financing Order also contains certain requirements for interest rates,
maturities, issuances, expenses and use of proceeds. Under the June 2003
Financing Order, our common equity as a percentage of total capitalization must
be at least 30%.
In July 2003, CenterPoint Energy requested authority from the SEC to issue
debt that is secured by our stock in an amount of up to $2.85 billion in
connection with the any extension or refinancing of CenterPoint Energy's
existing obligations under its bank facility. Currently, our stock secures any
obligations of CenterPoint Energy under its bank facility.
Cash Flows From Operations -- Reliant Resources as a Significant Customer.
To date, we have sold a substantial portion of our auctioned capacity
entitlements to subsidiaries of Reliant Resources. For more information
regarding the impact that Reliant Resources' financial condition may have on our
cash flows, please read "Risk Factors" in Item 5 of Part II of this report.
Dividend Policy. We intend to pay regular quarterly cash dividends on our
common stock. Our board of directors will determine the amount of future
dividends in light of:
- any applicable contractual restrictions governing our ability to pay
dividends, including our agreements with CenterPoint Energy to ensure
its compliance with the terms of the Reliant Resources Option
agreement;
- applicable legal requirements, including those under the 1935 Act;
- our earnings and cash flows;
- our financial condition; and
- other factors our board of directors deems relevant.
On August 7, 2003, our board of directors declared a quarterly cash dividend
of $0.25 per share of common stock payable on September 19, 2003 to shareholders
of record as of the close of business on August 26, 2003. For a description of
certain contractual provisions governing our ability to pay dividends, please
read "Market for Common Stock and
20
Related Stockholder Matters" in Item 5 of the Texas Genco Form 10-K.
We expect our liquidity and capital requirements will be affected by our:
- capital requirements related to environmental compliance and other
maintenance projects;
- dividend policy;
- debt service requirements; and
- working capital requirements.
Money Pool. At December 31, 2002 and June 30, 2003, we had $86 million and
$129 million respectively, borrowed from affiliates through the CenterPoint
Energy money pool. Through the money pool, we and certain of our affiliates can
borrow or invest on a short-term basis. The June 2003 Financing Order limits the
amount of our borrowings from the money pool to $600 million. Funding needs are
aggregated and external borrowing or investing is based on the net cash
position. The money pool's net funding requirements are generally met by
borrowings of CenterPoint Energy. The terms of the money pool are in accordance
with requirements applicable to registered public utility holding companies
under the 1935 Act and the June 2003 Financing Order. The money pool may not
provide sufficient funds to meet our cash needs. If we obtain certification by
the Federal Energy Regulatory Commission as an "exempt wholesale generator"
(which certification we plan to seek), under the 1935 Act we will no longer be
able to participate with CenterPoint Energy's utility subsidiaries in the same
money pool and will be required to maintain our own liquidity facility or
participate in a separate money pool from the regulated utilities.
Pension Plan. As discussed in Note 6(a) to the Texas Genco Form 10-K, which
is incorporated by reference herein, we participate in CenterPoint Energy's
qualified non-contributory pension plan covering substantially all employees.
Pension expense for 2003 is estimated to be $17 million based on an expected
return on plan assets of 9.0% and a discount rate of 6.75% as of December 31,
2002. Future changes in plan asset returns, assumed discount rates and various
other factors related to the pension will impact our future pension expense and
liabilities. We cannot predict with certainty what these factors will be in the
future. Additionally, we expect that a separate pension plan will be established
for us in 2004. We would receive an allocation of assets from the CenterPoint
Energy pension plan pursuant to rules and regulations under the Employee
Retirement Income Security Act of 1974 and record its pension obligations in
accordance with SFAS No. 87, "Employer's Accounting for Pensions". It is
anticipated that a plan established for us will be underfunded and that such
underfunding could be significant. Changes in interest rates and the market
values of the securities held by the CenterPoint Energy pension plan during 2003
could materially, positively or negatively, change the funding status of a plan
established for us.
CRITICAL ACCOUNTING POLICIES
A critical accounting policy is one that is both important to the
presentation of our financial condition and results of operations and requires
management to make difficult, subjective or complex accounting estimates. An
accounting estimate is an approximation made by management of a financial
statement element, item or account in the financial statements. Accounting
estimates in our historical consolidated financial statements measure the
effects of past business transactions or events, or the present status of an
asset or liability. The accounting estimates described below require us to make
assumptions about matters that are highly uncertain at the time the estimate is
made. Additionally, different estimates that we could have used or changes in an
accounting estimate that are reasonable likely to occur could have a material
impact on the presentation of our financial condition or results of operations.
We base our estimates on historical experience and on various other assumptions
that we believe are reasonable under the circumstances, the results of which
form the basis for making judgments. These estimates may change as new events
occur, as more experience is acquired, as additional information is obtained and
as our operating environment changes. We believe the following critical
accounting policies involve the application of accounting estimates for which a
change in the estimate is inseparable from the effect of a change in accounting
principle. Accordingly, these accounting policies have been reviewed and
discussed with the audit committee of the board of directors.
21
REVENUE RECOGNITION
Starting January 1, 2002, we have two primary components of revenue: (1)
capacity revenues, which entitle the owner to power, and (2) energy revenues,
which are intended to cover the costs of fuel for the actual electricity
produced. Capacity payments are billed and collected one month prior to actual
energy deliveries and are recorded as deferred revenue until the month of actual
energy delivery. At that point, the deferred revenue is reversed, and both
capacity and energy payment revenues are recognized. As of December 31, 2002,
and June 30, 2003, $49 million and $89 million, respectively, of deferred
capacity revenue was recorded in our Consolidated Balance Sheets.
IMPAIRMENT OF LONG-LIVED ASSETS
Long-lived assets, which primarily include property, plant and equipment
(PP&E), comprise $4.1 billion or 88% of our total assets as of June 30, 2003. We
make judgments and estimates in conjunction with the carrying value of these
assets, including amounts to be capitalized, depreciation and amortization
methods and useful lives. We evaluate our PP&E for impairment whenever
indicators of impairment exist. Accounting standards require that if the sum of
the undiscounted expected future cash flows from a company's asset is less than
the carrying value of the asset, an asset impairment must be recognized. The
amount of impairment recognized is calculated by subtracting the fair value of
the asset from the carrying value of the asset.
As a result of the distribution of approximately 19% of our common stock to
CenterPoint Energy's shareholders on January 6, 2003, we re-evaluated these
assets for impairment as of December 31, 2002 in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." As of December
31, 2002, no impairment had been indicated.
NEW ACCOUNTING PRONOUNCEMENTS
Effective January 1, 2003, we adopted SFAS No. 143. SFAS No. 143 requires
the fair value of an asset retirement obligation to be recognized as a liability
is incurred and capitalized as part of the cost of the related tangible
long-lived assets. Over time, the liability is accreted to its present value
each period, and the capitalized cost is depreciated over the useful life of the
related asset. Retirement obligations associated with long-lived assets included
within the scope of SFAS No. 143 are those for which a legal obligation exists
under enacted laws, statutes and written or oral contracts, including
obligations arising under the doctrine of promissory estoppel.
We have identified retirement obligations for nuclear decommissioning at the
South Texas Project and for lignite mine operations at the Jewett mine supplying
the Limestone electric generation facility. Prior to adoption of SFAS No. 143,
we had recorded liabilities for nuclear decommissioning and the reclamation of
the lignite mine. Liabilities were recorded for estimated decommissioning
obligations of $139.7 million and $39.7 million for reclamation of the lignite
at December 31, 2002. Upon adoption of SFAS No. 143 on January 1, 2003, we
reversed the $139.7 million previously accrued for the nuclear decommissioning
of the South Texas Project and recorded a plant asset of $99.1 million offset by
accumulated depreciation of $35.8 million as well as a retirement obligation of
$186.7 million. The $16.3 million difference between amounts previously recorded
and the amounts recorded upon adoption of SFAS No. 143 is being deferred as a
liability due to regulatory requirements. We also reversed the $39.7 million we
had previously recorded for the Jewett mine reclamation and recorded a plant
asset of $1.9 million offset by accumulated depreciation of $0.4 million as well
as a retirement obligation of $3.8 million. The $37.4 million difference between
amounts previously recorded and the amounts recorded upon adoption of SFAS No.
143 was recorded as a cumulative effect of accounting change. We have also
identified other asset retirement obligations that cannot be calculated because
the assets associated with the retirement obligations have an indeterminate
life.
22
The following represents the balances of the asset retirement obligation as
of January 1, 2003 and the additions and accretion of the asset retirement
obligation for the six months ended June 30, 2003:
BALANCE, LIABILITIES LIABILITIES CASH FLOW BALANCE,
JANUARY 1, 2003 INCURRED SETTLED ACCRETION REVISIONS JUNE 30, 2003
--------------- ----------- ----------- --------- --------- -------------
(IN MILLIONS)
Nuclear decommissioning.... $ 186.7 -- -- $ 4.5 -- $ 191.2
Jewett lignite mine........ 3.8 -- -- 0.2 -- 4.0
--------------- ----------- ----------- ---------- --------- -------------
$ 190.5 -- -- $ 4.7 -- $ 195.2
=============== =========== =========== ========== ========= =============
The following represents the pro-forma effect on our net income for the
three months and six months ended June 30, 2002, as if we had adopted SFAS No.
143 as of January 1, 2002:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 2002 JUNE 30, 2002
------------- ------------
(IN THOUSANDS)
Net loss as reported .................................. $ (18,292) $ (52,986)
Pro-forma net loss..................................... (18,104) (52,608)
DILUTED EARNINGS PER SHARE:
Net loss as reported .................................. $ (0.23) $ (0.66)
Pro-forma net loss..................................... (0.23) (0.66)
The following represents our asset retirement obligations on a pro-forma
basis as if we had adopted SFAS No. 143 as of December 31, 2002:
AS REPORTED PRO-FORMA
----------- ---------
(IN MILLIONS)
Nuclear decommissioning................................ $ 139.7 $ 186.7
Jewett lignite mine.................................... 39.7 3.8
----------- ---------
Total................................................ $ 179.4 $ 190.5
=========== =========
We have previously recognized removal costs as a component of depreciation
expense. Upon adoption of SFAS No. 143, we reversed $115 million of previously
recognized removal costs as a cumulative effect of accounting change. The total
cumulative effect recognized upon adoption of SFAS No. 143 was $99 million
after-tax ($152 million pre-tax).
In April 2002, the Financial Accounting Standards Board (FASB) issued SFAS
No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections" (SFAS No. 145). SFAS No. 145
eliminates the current requirement that gains and losses on debt extinguishment
must be classified as extraordinary items in the income statement. Instead, such
gains and losses will be classified as extraordinary items only if they are
deemed to be unusual and infrequent. SFAS No. 145 also requires that capital
leases that are modified so that the resulting lease agreement is classified as
an operating lease be accounted for as a sale-leaseback transaction. The changes
related to debt extinguishment are effective for fiscal years beginning after
May 15, 2002, and the changes related to lease accounting are effective for
transactions occurring after May 15, 2002. We have applied this guidance as it
relates to lease accounting and the accounting provisions related to debt
extinguishment. Upon adoption of SFAS No. 145, any gain or loss on
extinguishment of debt that was classified as an extraordinary item in prior
periods presented is required to be reclassified. No such reclassification was
required in the three month or six month period ended June 30, 2002.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities" (SFAS No. 146). SFAS No. 146
nullifies Emerging Issues Task Force (EITF) No. 94-3, "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)" (EITF No. 94-3). The
principal difference between SFAS No. 146 and EITF No. 94-3 relates to the
requirements for recognition of a liability for costs associated with an exit or
disposal activity. SFAS No. 146 requires that a liability be recognized for a
cost associated with an exit or disposal activity when it is incurred. A
liability is incurred when a transaction or event occurs that leaves an entity
little or no discretion to
23
avoid the future transfer or use of assets to settle the liability. Under EITF
No. 94-3, a liability for an exit cost was recognized at the date of an entity's
commitment to an exit plan. In addition, SFAS No. 146 also requires that a
liability for a cost associated with an exit or disposal activity be recognized
at its fair value when it is incurred. SFAS No. 146 is effective for exit or
disposal activities that are initiated after December 31, 2002. We adopted the
provisions of SFAS No. 146 on January 1, 2003.
In November 2002, the FASB issued FASB Interpretation No. (FIN) 45
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others" (FIN 45). FIN 45 requires that a
liability be recorded in the guarantor's balance sheet upon issuance of certain
guarantees. In addition, FIN 45 requires disclosures about the guarantees that
an entity has issued. The provision for initial recognition and measurement of
the liability will be applied on a prospective basis to guarantees issued or
modified after December 31, 2002. The disclosure provisions of FIN 45 are
effective for financial statements of interim or annual periods ending after
December 15, 2002. The adoption of FIN 45 did not have a material impact on our
results of operations or financial condition.
In January 2003, the FASB issued FIN No. 46 "Consolidation of Variable
Interest Entities, an Interpretation of Accounting Research Bulletin No. 51"
(FIN 46). FIN 46 requires certain variable interest entities to be consolidated
by the primary beneficiary of the entity if the equity investors in the entity
do not have the characteristics of a controlling financial interest or do not
have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. FIN 46 is
effective for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first interim
or annual period beginning after June 15, 2003. The adoption of FIN 46 did not
have a material impact on our consolidated financial statements.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities" (SFAS No. 149). SFAS No. 149 has
added additional criteria which were effective on July 1, 2003 for new,
acquired, or newly modified forward contracts. We engage in forward contracts
for the sale of power. The majority of these forward contracts are entered into
either through state mandated Texas Utility Commission auctions or contractually
mandated auctions. All of our contracts resulting from these auctions specify
the product types, the plant or group of plants from which the auctioned
products are derived, the delivery location and specific delivery requirements,
and pricing for each of the products. We have applied the criteria from current
accounting literature, including SFAS No. 133 Implementation Issue No. C-15 -
"Scope Exceptions: Normal Purchases and Normal Sales Exception for Option-Type
Contracts and Forward Contracts in Electricity", to both the state mandated and
the contractually mandated auction contracts and believe they meet the
definition of capacity contracts. Accordingly, we consider these contracts as
normal sales contracts rather than as derivatives. We have evaluated our forward
commodity contracts under the new requirements of SFAS No. 149. The adoption of
SFAS No. 149 will not change previous accounting conclusions relating to forward
power sales contracts entered into in connection with the state mandated or
contractually mandated auctions and the adoption will not have a material effect
on our financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
Beginning in 2002, we have contributed $2.9 million per year to trusts
established to fund our share of the decommissioning costs for the South Texas
Project. The securities held by the trusts for decommissioning costs had an
estimated fair value of $174 million as of June 30, 2003, of which approximately
40% were debt securities that subject us to risk of loss of fair value with
movements in market interest rates. If interest rates were to increase by 10%
from their levels at June 30, 2003, the fair value of the fixed-rate debt
securities would decrease by approximately $1 million. In addition, the risk of
an economic loss is mitigated because CenterPoint Energy has agreed to indemnify
us for any shortfall of the trust to cover decommissioning costs.
EQUITY MARKET VALUE RISK
As discussed above under "-- Interest Rate Risk," we contribute to trusts
established to fund our share of the decommissioning costs for the South Texas
Project, which held debt and equity securities as of June 30, 2003. The equity
securities expose us to losses in fair value. If the market prices of the
individual equity securities were to
24
decrease by 10% from their levels at June 30, 2003, the resulting loss in fair
value of these securities would be approximately $10 million. Currently, the
risk of an economic loss is mitigated as discussed above under "-- Interest Rate
Risk."
COMMODITY PRICE RISK
Our gross margins are dependent upon the market price for power in the
ERCOT market. Our gross margins are primarily derived from the sale of capacity
entitlements associated with our large, solid fuel base-load generating units,
including our Limestone and W.A. Parish facilities and our interest in the South
Texas Project. The gross margins generated from payments associated with the
capacity of these units are directly impacted by natural gas prices. Since the
fuel costs for our base-load units are largely fixed under long-term contracts,
they are generally not subject to significant daily and monthly fluctuations.
However, the market price for power in the ERCOT market is directly affected by
the price of natural gas. Because natural gas is the marginal fuel of facilities
serving the ERCOT market during most hours, its price has a significant
influence on the price of electric power. As a result, the price customers are
willing to pay for entitlements to our solid fuel base-load capacity generally
rises and falls with natural gas prices.
ITEM 4. CONTROLS AND PROCEDURES
In accordance with Exchange Act Rules 13a-15 and 15d-15, we carried out an
evaluation, under the supervision and with the participation of management,
including our principal executive officer and principal financial officer, of
the effectiveness of our disclosure controls and procedures as of the end of the
period covered by this report. Based on that evaluation, our principal executive
officer and principal financial officer concluded that our disclosure controls
and procedures were effective as of June 30, 2003 to provide assurance that
information required to be disclosed in our reports filed or submitted under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission's rules and forms.
There has been no change in our internal controls over financial reporting
that occurred during the three months ended June 30, 2003 that has materially
affected, or is reasonably likely to materially affect, our internal controls
over financial reporting.
25
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
We are, from time to time, a party to litigation arising in the normal
course of our business, most of which involves contract disputes or claims for
personal injury and property damage incurred in connection with our operations.
We are not currently involved in any litigation that we expect will have a
material adverse effect on our financial condition, results of operations and
cash flows. For a description of a number of lawsuits involving claims of
asbestos exposure at properties owned by us, please read "Business --
Environmental Matters -- Asbestos" in Item 1 of the Texas Genco Form 10-K, which
is incorporated herein by reference. For a description of a lawsuit involving
one of our fuel suppliers, please read "Supplier Suits" in Note 4(a) to our
Interim Financial Statements, which is incorporated herein by reference.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
At the annual meeting of our shareholders held on May 29, 2003, the matters
voted upon and the number of votes cast for, against or withheld, as well as the
number of abstentions and broker non-votes as to such matters (including a
separate tabulation with respect to each nominee for office) were as stated
below:
The following nominees for directors were elected to serve a one-year term
expiring 2004 (there were no broker non-votes):
Directors For Withhold
- -------------------------- ---------- ---------
J. Evans Attwell 78,319,074 325,748
Donald R. Campbell 78,317,729 327,093
Robert J. Cruikshank 78,373,902 270,920
Patricia A. Hemingway Hall 78,383,803 261,019
David M. McClanahan 76,608,587 2,036,235
Scott E. Rozzell 76,608,815 2,036,007
David G. Tees 76,610,544 2,034,278
Gary L. Whitlock 76,791,663 1,853,159
The ratification of the appointment of Deloitte & Touche LLP as independent
accountants and auditors for Texas Genco for 2003 was approved with 78,331,112
votes for, 284,097 votes against, 29,613 abstentions and no broker non-votes.
ITEM 5. OTHER INFORMATION.
RISK FACTORS
PRINCIPAL RISK FACTORS AFFECTING OUR BUSINESS
OUR REVENUES AND RESULTS OF OPERATIONS ARE IMPACTED BY MARKET RISKS THAT
ARE BEYOND OUR CONTROL.
We sell electric generation capacity, energy and ancillary services in the
ERCOT market. The ERCOT market consists of the majority of the population
centers in the State of Texas and represents approximately 85% of the demand for
power in the state. Under the Texas electric restructuring law, we and other
power generators in Texas are not subject to traditional cost-based regulation
and, therefore, may sell electric generation capacity, energy and ancillary
services to wholesale purchasers at prices determined by the market. As a
result, we are not guaranteed any rate of return on our capital investments
through mandated rates, and our revenues and results of operations depend, in
large part, upon prevailing market prices for electricity in the ERCOT market.
Market prices for electricity, generation capacity, energy and ancillary
services may fluctuate substantially. Our gross margins are primarily derived
from the sale of capacity entitlements associated with our large, solid fuel
base-load generating units, including our coal and lignite fueled generating
stations and the South Texas Project. The gross margins generated from payments
associated with the capacity of these units are directly impacted by natural gas
prices. Since the fuel costs for our base-load units are largely fixed under
long-term contracts, they are generally not subject to significant daily and
monthly fluctuations. However, the market price for power in the ERCOT market is
directly
26
affected by the price of natural gas. Because natural gas is the marginal fuel
for facilities serving the ERCOT market during most hours, its price has a
significant influence on the price of electric power. As a result, the price
customers are willing to pay for entitlements to our solid fuel-fired base-load
capacity generally rises and falls with natural gas prices.
Market prices in the ERCOT market may also fluctuate substantially due to
other factors. Such fluctuations may occur over relatively short periods of
time. Volatility in market prices may result from:
- oversupply or undersupply of generation capacity,
- power transmission or fuel transportation constraints or
inefficiencies,
- weather conditions,
- seasonality,
- availability and market prices for natural gas, crude oil and refined
products, coal, enriched uranium and uranium fuels,
- changes in electricity usage,
- additional supplies of electricity from existing competitors or new
market entrants as a result of the development of new generation
facilities or additional transmission capacity,
- illiquidity in the ERCOT market,
- availability of competitively priced alternative energy sources,
- natural disasters, wars, embargoes, terrorist attacks and other
catastrophic events, and
- federal and state energy and environmental regulation and legislation.
THERE IS CURRENTLY A SURPLUS OF GENERATING CAPACITY IN THE ERCOT MARKET AND WE
EXPECT THE MARKET FOR WHOLESALE POWER TO BE HIGHLY COMPETITIVE.
The amount by which power generating capacity exceeded peak demand (reserve
margin) in the ERCOT market has exceeded 20% since 2001, and the Texas Utility
Commission and the ERCOT Independent System Operator (ISO) have forecasted the
reserve margin for 2003 to continue to exceed 20%. The commencement of
commercial operation of new facilities in the ERCOT market will increase the
competitiveness of the wholesale power market, which could have a material
adverse effect on our results of operations, financial condition, cash flows and
the market value of our assets.
Our competitors include generation companies affiliated with Texas-based
utilities, independent power producers, municipal and co-operative generators
and wholesale power marketers. The unbundling of vertically integrated utilities
into separate generation, transmission and distribution, and retail businesses
pursuant to the Texas electric restructuring law could result in a significant
number of additional competitors participating in the ERCOT market. Some of our
competitors may have greater financial resources, lower cost structures, more
effective risk management policies and procedures, greater ability to incur
losses, greater potential for profitability from ancillary services, and greater
flexibility in the timing of their sale of generating capacity and ancillary
services than we do.
WE ARE SUBJECT TO OPERATIONAL AND MARKET RISKS ASSOCIATED WITH OUR CAPACITY
AUCTIONS.
We are obligated to sell substantially all of our available capacity and
related ancillary services through 2003 pursuant to capacity auctions. In these
auctions, we sell firm entitlements on a forward basis to capacity and ancillary
services dispatched within specified operational constraints. Although we have
reserved a portion of our aggregate net generation capacity from our capacity
auctions for planned or forced outages at our facilities, unanticipated plant
outages or other problems with our generation facilities could result in our
firm capacity and ancillary services commitments exceeding our available
generation capacity. As a result, we could be required to obtain replacement
power from third parties in the open market to satisfy our firm commitments that
could result in
27
significant additional costs. In addition, an unexpected outage at one of our
lower cost facilities could require us to run one of our higher cost plants in
order to satisfy our obligations even though the energy payments for the
dispatched power are based on the cost at the lower-cost facility.
The mechanics, regulations and agreements governing our capacity auctions
are complex. The state mandated auctions require, among other things, our
capacity entitlements to be sold in pre-determined amounts. The characteristics
of the capacity entitlements we sell in state mandated auctions are defined by
rules adopted by the Texas Utility Commission and, therefore, cannot be changed
to respond to market demands or operational requirements without approval by the
Texas Utility Commission.
THE OPERATION OF OUR POWER GENERATION FACILITIES INVOLVES RISKS THAT COULD
ADVERSELY AFFECT OUR REVENUES, COSTS, RESULTS OF OPERATIONS, FINANCIAL
CONDITION AND CASH FLOWS.
We are subject to various risks associated with operating our power
generation facilities, any of which could adversely affect our revenues, costs,
results of operations, financial condition and cash flows. These risks include:
- operating performance below expected levels of output or efficiency,
- breakdown or failure of equipment or processes,
- disruptions in the transmission of electricity,
- shortages of equipment, material or labor,
- labor disputes,
- fuel supply interruptions,
- limitations that may be imposed by regulatory requirements, including,
among others, environmental standards,
- limitations imposed by the ERCOT ISO,
- violations of permit limitations,
- operator error, and
- catastrophic events such as fires, hurricanes, explosions, floods,
terrorist attacks or other similar occurrences.
A significant portion of our facilities were constructed many years ago.
Older generation equipment, even if maintained in accordance with good
engineering practices, may require significant capital expenditures to keep it
operating at high efficiency and to meet regulatory requirements. This equipment
is also likely to require periodic upgrading and improvement. Any unexpected
failure to produce power, including failure caused by breakdown or forced
outage, could result in increased costs of operations and reduced earnings.
WE RELY ON POWER TRANSMISSION FACILITIES THAT WE DO NOT OWN OR CONTROL AND
THAT ARE SUBJECT TO TRANSMISSION CONSTRAINTS WITHIN THE ERCOT MARKET. IF THESE
FACILITIES FAIL TO PROVIDE US WITH ADEQUATE TRANSMISSION CAPACITY, WE MAY NOT
BE ABLE TO DELIVER WHOLESALE ELECTRIC POWER TO OUR CUSTOMERS AND WE MAY INCUR
ADDITIONAL COSTS.
We depend on transmission and distribution facilities owned and operated by
CenterPoint Houston and by others to deliver the wholesale electric power we
sell from our power generation facilities to our customers, who in turn deliver
power to the end users. If transmission is disrupted, or if transmission
capacity infrastructure is inadequate, our ability to sell and deliver wholesale
electric energy may be adversely impacted.
The single control area of the ERCOT market is currently organized into
four congestion zones. Transmission congestion between the zones could impair
our ability to schedule power for transmission across zonal boundaries, which
are defined by the ERCOT ISO, thereby inhibiting our efforts to match our
facility scheduled outputs with our customer scheduled requirements. In
addition, power generators participating in the ERCOT market could be liable for
congestion costs associated with transferring power between zones.
28
OUR RESULTS OF OPERATIONS, FINANCIAL CONDITION AND CASH FLOWS COULD BE
ADVERSELY IMPACTED BY A DISRUPTION OF OUR FUEL SUPPLIES.
We rely primarily on natural gas, coal, lignite and uranium to fuel our
generation facilities. We purchase our fuel from a number of different suppliers
under long-term contracts and on the spot market. Under our capacity auctions,
we sell firm entitlements to capacity and ancillary services. Therefore, any
disruption in the delivery of fuel could prevent us from operating our
facilities, or force us to enter into alternative arrangements at higher than
prevailing market prices, to meet our auction commitments, which could adversely
affect our results of operations, financial condition and cash flows.
TO DATE, WE HAVE SOLD A SUBSTANTIAL PORTION OF OUR AUCTIONED CAPACITY
ENTITLEMENTS TO SUBSIDIARIES OF RELIANT RESOURCES. ACCORDINGLY, OUR RESULTS
OF OPERATIONS, FINANCIAL CONDITION AND CASH FLOWS COULD BE ADVERSELY AFFECTED
IF RELIANT RESOURCES DECLINED TO PARTICIPATE IN OUR FUTURE AUCTIONS OR FAILED
TO MAKE PAYMENTS WHEN DUE UNDER RELIANT RESOURCES' PURCHASED ENTITLEMENTS.
Subsidiaries of Reliant Resources purchased entitlements to 63% of our
available 2002 capacity and through July 2003 had purchased 71% of our available
2003 capacity. Reliant Resources made these purchases either through the
exercise of its contractual rights to purchase 50% of the entitlements we
auction in our contractually mandated auctions or through the submission of
bids. In the event Reliant Resources declined to participate in our future
auctions or failed to make payments when due, our results of operations,
financial condition and cash flows could be adversely affected. As of June 30,
2003, Reliant Resources' securities ratings are below investment grade. We have
been granted a security interest in accounts receivable and/or notes associated
with the accounts receivable of certain subsidiaries of Reliant Resources to
secure up to $250 million in purchase obligations.
WE MAY INCUR SUBSTANTIAL COSTS AND LIABILITIES AS A RESULT OF OUR OWNERSHIP OF
NUCLEAR FACILITIES.
We own a 30.8% interest in the South Texas Project, a nuclear powered
generation facility. As a result, we are subject to risks associated with the
ownership and operation of nuclear facilities. These risks include:
- the potential harmful effects on the environment and human health
resulting from the operation of nuclear facilities and the storage,
handling and disposal of radioactive materials,
- limitations on the amounts and types of insurance commercially
available to cover losses that might arise in connection with nuclear
operations, and
- uncertainties with respect to the technological and financial aspects
of decommissioning nuclear plants at the end of their licensed lives.
The NRC has broad authority under federal law to impose licensing and
safety-related requirements for the operation of nuclear generation facilities.
In the event of non-compliance, the NRC has the authority to impose fines, shut
down a unit, or both, depending upon its assessment of the severity of the
situation, until compliance is achieved. Revised safety requirements promulgated
by the NRC could necessitate substantial capital expenditures at nuclear plants.
In addition, although we have no reason to anticipate a serious nuclear incident
at the South Texas Project, if an incident did occur, it could have a material
adverse effect on our results of operations, financial condition and cash flows.
OTHER RISKS
WE MAY NOT HAVE ACCESS TO SUFFICIENT CAPITAL IN THE AMOUNTS AND AT THE TIMES
NEEDED TO FINANCE OUR BUSINESS.
To date, our capital has been provided by internally generated cash flows
and borrowings from a "money pool" through which we and certain of our
affiliates can borrow or invest on a short-term basis. Funding needs are
aggregated and external borrowing or investing is based on the net cash
position. The money pool's net funding requirements are generally met with
short-term borrowings of CenterPoint Energy. In the event CenterPoint Energy
were to experience liquidity problems or otherwise failed to perform, we may be
unable to obtain third party financing. At June 30, 2003, we had borrowings of
$129 million from the money pool. We can give no assurances that our current and
future capital structure, operating performance, financial condition and cash
29
flows will permit us to access the capital markets or to obtain other financing
as needed to meet our working capital requirements and projected future capital
expenditures on favorable terms. The amount of any debt issuance by us is
expected to be affected by the market's perception of our creditworthiness,
market conditions and factors affecting our industry. Our projected future
capital expenditures are substantial. Our ability to secure third party credit
lines or other debt financing may be adversely impacted by the factors described
in this section, including the nature of our business, which may lead to
volatility in our financial results and cash flows. CenterPoint Energy has
agreed to lend funds to us from time to time upon our request until the earlier
of the closing date on which Reliant Resources acquires our common stock from
CenterPoint Energy pursuant to the Reliant Resources Option or upon the
expiration of the Reliant Resources option. Please read "Management's Discussion
and Analysis of Financial Condition and Results of Operations - Liquidity and
Capital Resources - Future Sources and Uses of Cash - Capital Requirements."
In addition, our ability to raise capital is restricted under our
agreements with CenterPoint Energy. These restrictions limit our ability to:
- issue additional equity securities;
- encumber our assets; or
- incur indebtedness, except to satisfy requirements for operating and
maintenance expenditures and other capital expenditures contemplated
under our agreements with CenterPoint Energy, to meet our working
capital needs, or to refinance indebtedness incurred for the foregoing
purposes.
CenterPoint Energy and its subsidiaries, including us, are subject to
regulation by the SEC under the 1935 Act. The 1935 Act, among other things,
limits the ability of a holding company and its subsidiaries to issue debt and
equity securities without prior authorization, restricts the source of dividend
payments to funds from current and retained earnings without prior
authorization, regulates sales and acquisitions of certain assets and businesses
and governs affiliate transactions. Approval of filings under the 1935 Act can
take extended periods.
CenterPoint Energy and its subsidiaries, including us, received an order
from the SEC under the 1935 Act on June 30, 2003 relating to financing
activities, which is effective until June 30, 2005. We must seek a new order
before the expiration date. Although authorized levels of financing, together
with current levels of liquidity, are believed to be adequate during the period
the order is effective, unforeseen events could result in capital needs in
excess of authorized amounts, necessitating further authorization from the SEC.
The United States Congress is currently considering legislation which has
a provision that would repeal the 1935 Act. We cannot predict at this time
whether this legislation or any variation thereof will be adopted or, if
adopted, the effect of any such law on our business.
We are an 81% owned subsidiary of CenterPoint Energy. As a result of this
relationship, the financial condition of CenterPoint Energy could affect our
access to capital, our credit standing and our financial condition.
OUR OPERATIONS ARE SUBJECT TO EXTENSIVE REGULATION, INCLUDING ENVIRONMENTAL
REGULATION. IF WE FAIL TO COMPLY WITH APPLICABLE REGULATIONS OR OBTAIN OR
MAINTAIN ANY NECESSARY GOVERNMENTAL PERMIT OR APPROVAL, WE MAY BE SUBJECT TO
CIVIL, ADMINISTRATIVE AND/OR CRIMINAL PENALTIES THAT COULD ADVERSELY IMPACT
OUR RESULTS OF OPERATIONS, FINANCIAL CONDITION AND CASH FLOWS.
Our operations are subject to complex and stringent energy, environmental
and other governmental laws and regulations. The acquisition, ownership and
operation of power generation facilities require numerous permits, approvals and
certificates from federal, state and local governmental agencies. These
facilities are subject to regulation by the Texas Utility Commission regarding
non-rate matters. Existing regulations may be revised or reinterpreted, new laws
and regulations may be adopted or become applicable to us or any of our
generation facilities or future changes in laws and regulations may have a
detrimental effect on our business.
Operation of the South Texas Project is subject to regulation by the NRC.
This regulation involves testing, evaluation and modification of all aspects of
plant operation in light of NRC safety and environmental requirements.
Continuous demonstrations to the NRC that plant operations meet applicable
requirements are also required. The NRC has the ultimate authority to determine
whether any nuclear powered generating unit may operate.
Water for certain of our facilities is obtained from public water
authorities. New or revised interpretations of existing agreements by those
authorities or changes in price or availability of water may have a detrimental
effect on our business.
30
Our business is subject to extensive environmental regulation by federal,
state and local authorities. We are required to comply with numerous
environmental laws and regulations and to obtain numerous governmental permits
in operating our facilities. We may incur significant additional costs to comply
with these requirements. If we fail to comply with these requirements or with
any other regulatory requirements that apply to our operations, we could be
subject to administrative, civil and/or criminal liability and fines, and
regulatory agencies could take other actions seeking to curtail our operations.
These liabilities or actions could adversely impact our results of operations,
financial condition and cash flows.
Existing environmental regulations could be revised or reinterpreted, new
laws and regulations could be adopted or become applicable to us or our
facilities, and future changes in environmental laws and regulations could
occur, including potential regulatory and enforcement developments related to
air emissions. If any of these events occurs, our business, results of
operations, financial condition and cash flows could be adversely affected.
We may not be able to obtain or maintain from time to time all required
environmental regulatory approvals. If there is a delay in obtaining any
required environmental regulatory approvals or if we fail to obtain and comply
with them, we may not be able to operate our facilities or we may be required to
incur additional costs. We are generally responsible for all on-site liabilities
associated with the environmental condition of our power generation facilities,
regardless of when the liabilities arose and whether the liabilities are known
or unknown. These liabilities may be substantial.
IF THE ERCOT MARKET DOES NOT FUNCTION IN THE MANNER CONTEMPLATED BY THE TEXAS
ELECTRIC RESTRUCTURING LAW, OUR BUSINESS PROSPECTS, RESULTS OF OPERATIONS,
FINANCIAL CONDITION AND CASH FLOWS COULD BE ADVERSELY IMPACTED.
The competitive electric market in Texas became fully operational in
January 2002, and none of us, the Texas Utility Commission, ERCOT or other
market participants has any significant operating history under the market
framework created by the Texas electric restructuring law. The initiatives under
the Texas electric restructuring law have had a significant impact on the nature
of the electric power industry in Texas and the manner in which participants in
the ERCOT market conduct their business. These changes are ongoing, and we
cannot predict the future development of the ERCOT market or the ultimate effect
that this changing regulatory environment will have on our business.
Some restructured markets in other states have experienced supply problems
and extreme price volatility. If the ERCOT market does not function as intended
by the Texas electric restructuring law, our results of operations, financial
condition and cash flows could be adversely affected. In addition, any market
failures could lead to revisions or reinterpretations of the Texas electric
restructuring law, the adoption of new laws and regulations applicable to us or
our facilities and other future changes in laws and regulations that may have a
detrimental effect on our business.
OUR INSURANCE COVERAGE MAY NOT BE SUFFICIENT. INSUFFICIENT INSURANCE COVERAGE
AND INCREASED INSURANCE COSTS COULD ADVERSELY IMPACT OUR RESULTS OF
OPERATIONS, FINANCIAL CONDITION AND CASH FLOWS.
We currently have general liability and property insurance in effect to
cover certain of our facilities in amounts that we consider appropriate. Such
policies are subject to certain limits and deductibles and do not include
business interruption coverage. We cannot assure you that insurance coverage
will be available in the future on commercially reasonable terms or that the
insurance proceeds received for any loss of or any damage to any of our
facilities will be sufficient to restore the loss or damage without negative
impact on our results of operations, financial condition and cash flows. The
costs of our insurance coverage have increased significantly in recent months
and may continue to increase in the future.
We and the other owners of the South Texas Project maintain nuclear
property and nuclear liability insurance coverage as required by law and
periodically review available limits and coverage for additional protection. The
owners of the South Texas Project currently maintain $2.75 billion in property
damage insurance coverage, which is above the legally required minimum, but is
less than the total amount of insurance currently available for such losses.
Under the federal Price Anderson Act, the maximum liability to the public of
owners of nuclear power plants was $9.3 billion as of June 30, 2003. Owners are
required under the Price Anderson Act to insure their liability for nuclear
incidents and protective evacuations. We and the other owners of the South Texas
Project currently maintain the required nuclear liability insurance and
participate in the industry retrospective rating plan. In addition, the security
procedures at this facility have recently been enhanced to provide additional
protection against terrorist attacks. All
31
potential losses or liabilities associated with the South Texas Project may not
be insurable, and the amount of insurance may not be sufficient to cover them.
In particular, our insurance policies are subject to certain limits and
deductibles and do not include business interruption coverage.
CHANGES IN TECHNOLOGY MAY ADVERSELY AFFECT OUR REVENUES AND RESULTS OF
OPERATIONS.
A significant portion of our generation facilities were constructed many
years ago and rely on older technologies. Some of our competitors may have newer
generation facilities and technologies that allow them to produce and sell power
more efficiently, which could adversely affect our results of operations,
financial condition and cash flows. In addition, research and development
activities are ongoing to improve alternate technologies to produce electricity,
including fuel cells, microturbines, windmills and photovoltaic (solar) cells.
It is possible that advances in these or other technologies will reduce the
current costs of electricity production utilizing newer facilities to a level
that is below that of our generation facilities. If this occurs, our generation
facilities will be less competitive and the value of our power plants could be
significantly impaired. Also, electricity demand could be reduced by increased
conservation efforts and advances in technology that could likewise
significantly reduce the value of our power generation facilities.
OUR REVENUES AND RESULTS OF OPERATIONS ARE SUBJECT TO RISKS THAT ARE BEYOND
OUR CONTROL, INCLUDING BUT NOT LIMITED TO FUTURE TERRORIST ATTACKS OR RELATED
ACTS OF WAR.
The cost of repairing damage to our operating subsidiaries' facilities due
to storms, natural disasters, wars, terrorist acts and other catastrophic
events, in excess of reserves established for such repairs, may adversely impact
our results of operations, financial condition and cash flows. The occurrence or
risk of occurrence of future terrorist activity may impact our results of
operations, financial condition and cash flows in unpredictable ways. These
actions could also result in adverse changes in the insurance markets and
disruptions of power and fuel markets. In addition, our electric transmission
and distribution, electric generation, natural gas distribution and pipeline and
gathering facilities could be directly or indirectly harmed by future terrorist
activity. The occurrence or risk of occurrence of future terrorist attacks or
related acts of war could also adversely affect the United States economy. A
lower level of economic activity could result in a decline in energy
consumption, which could adversely affect our revenues and margins and limit our
future growth prospects. Also, these risks could cause instability in the
financial markets and adversely affect our ability to access capital.
RISKS RELATED TO OUR RELATIONSHIPS WITH CENTERPOINT ENERGY AND RELIANT RESOURCES
WE WILL BE CONTROLLED BY CENTERPOINT ENERGY AS LONG AS IT OWNS A MAJORITY OF
OUR COMMON STOCK, AND OUR MINORITY SHAREHOLDERS WILL BE UNABLE TO AFFECT THE
OUTCOME OF SHAREHOLDER VOTING DURING THAT TIME. IF RELIANT RESOURCES
EXERCISES ITS OPTION TO ACQUIRE OUR STOCK OWNED BY CENTERPOINT ENERGY THAT IS
EXERCISABLE IN JANUARY 2004, WE WILL LIKEWISE BY CONTROLLED BY RELIANT
RESOURCES AND OUR MINORITY SHAREHOLDERS WILL BE UNABLE TO AFFECT THE OUTCOME
OF A SHAREHOLDER VOTE.
As a result of the January 6, 2003 distribution, CenterPoint Energy
indirectly owns approximately 81% of our outstanding common stock. As long as
CenterPoint Energy owns a majority of our outstanding common stock, it will
continue to be able to elect our entire board of directors, and our public
shareholders, by themselves, will not be able to affect the outcome of any
shareholder vote. Similarly, our public shareholders, by themselves, will not be
able to affect the outcome of any shareholder vote if Reliant Resources
exercises its option to acquire our common stock owned by CenterPoint Energy
that is exercisable in January 2004, as Reliant Resources would own
approximately 81% of our common stock in that event. For convenience, we
sometimes refer to CenterPoint Energy or Reliant Resources, as applicable, as
our "majority shareholder" when referring to either of them as the owner of 81%
or more of our common stock. In addition, CenterPoint Energy has stated that if
Reliant Resources does not exercise its option, CenterPoint Energy will consider
strategic alternatives for its interest in us, including a possible sale, which
could result in a third party becoming our majority shareholder. Reliant
Resources may choose not to exercise its option for a number of reasons,
including unfavorable market conditions or a lack of access to capital.
Our majority shareholder, subject to any fiduciary duty owed to our
minority shareholders under Texas law and restrictions under a master separation
agreement between CenterPoint Energy and Reliant Resources, will be able to
control all matters affecting us.
32
In addition, our majority shareholder may enter into credit agreements,
indentures or other contracts that limit the activities of its subsidiaries.
While we would not likely be contractually bound by these limitations, our
majority shareholder would likely cause its representatives on our board to
direct our business so as not to breach any of these agreements.
WE MAY HAVE POTENTIAL BUSINESS CONFLICTS OF INTEREST WITH CENTERPOINT ENERGY
WITH RESPECT TO OUR PAST AND ONGOING RELATIONSHIPS, AND BECAUSE OF CENTERPOINT
ENERGY'S CONTROLLING OWNERSHIP INTEREST, WE MAY NOT BE ABLE TO
RESOLVE THESE CONFLICTS ON TERMS POSSIBLE IN ARM'S LENGTH TRANSACTIONS.
Conflicts of interest may arise between CenterPoint Energy and us in a
number of areas relating to our past and ongoing relationships, including
proceedings, actions and decisions of legislative bodies and administrative
agencies, and our dividend policy. The agreements we have entered into with
CenterPoint Energy may be amended in the future upon agreement of the parties.
While we are controlled by CenterPoint Energy, CenterPoint Energy may be able to
require us to amend these agreements. We may not be able to resolve any
potential conflicts with CenterPoint Energy, and even if we do, the resolution
may be less favorable than if we were dealing with an unaffiliated party.
CONTRACTUAL RESTRICTIONS ON THE OPERATION OF OUR BUSINESS MAY ADVERSELY
AFFECT OUR ABILITY TO COMPETE WITH COMPANIES THAT ARE NOT SUBJECT TO SIMILAR
RESTRICTIONS.
Effective December 31, 2000, Reliant Resources and Reliant Energy entered
into a master separation agreement that now governs the rights and obligations
of CenterPoint Energy and Reliant Resources in connection with the business
separation plan of Reliant Energy adopted in response to the Texas electric
restructuring law. Reliant Resources also has an option to purchase the shares
of our stock owned by CenterPoint Energy that is exercisable in January 2004. We
have agreed to comply with certain restrictions governing our operations as
contemplated by the master separation agreement and option agreement. These
restrictions limit our ability to:
- merge or consolidate with another entity;
- sell assets;
- enter into long-term agreements and commitments for the purchase of
fuel or the purchase or sale of power outside the ordinary course of
business;
- engage in other businesses;
- construct or acquire new generation plants or capacity;
- engage in certain hedging transactions;
- encumber our assets;
- issue additional equity securities;
- pay special dividends; and
- make certain loans, investments or advances to, or engage in certain
transactions with, our affiliates.
IF RELIANT RESOURCES EXERCISES ITS OPTION TO ACQUIRE OUR STOCK OWNED BY
CENTERPOINT ENERGY IN 2004, THE TAX BASIS OF OUR ASSETS WILL BE ADJUSTED
UPWARDS OR DOWNWARDS TO REFLECT THE FAIR MARKET VALUE OF OUR BUSINESS AT THE
TIME OF THE PURCHASE.
We would be required to step up or step down the tax basis in all of our
assets following the date of the sale to be equivalent generally to the value of
the equity of our business, based upon the purchase price, plus the principal
amount of indebtedness at the time of the purchase. The resulting step-up or
step-down in the basis of our assets would impact our future tax liabilities. A
step-up would reduce our future tax liabilities, while a step-down would
increase our liabilities. We cannot currently project the impact of this tax
election because it is dependent on Reliant Resources'
33
exercise of its option in 2004, and the purchase price to be paid by Reliant
Resources in 2004, which is not known at this time.
34
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
The following exhibits are filed herewith:
Exhibits not incorporated by reference to a prior filing are designated by a
cross (+); all exhibits not so designated are incorporated by reference to a
prior filing as indicated.
SEC FILE
OR
EXHIBIT REGISTRATION EXHIBIT
NUMBER DESCRIPTION REPORT OR REGISTRATION STATEMENT NUMBER REFERENCE
- ------- ---------------------------- -------------------------------- ------ ---------
3.1 -- Amended and Restated Texas Genco Holdings, Inc.'s 1-31449 3.1
Articles of Incorporation ("Texas Genco") Form 10-K for
the year ended December 31, 2002
3.2 -- Amended and Restated Bylaws Texas Genco's Form 10-K for 1-31449 3.2
the year ended December 31, 2002
4.1 -- Specimen Stock Certificate Texas Genco's registration 1-31449 4.1
statement on Form 10
+10.1 -- Pledge Agreement dated as of
May 28, 2003, by Utility
Holding, LLC, in favor of JP
Morgan Chase Bank, as
administrative agent
+31.1 -- Section 302 Certification of
David G. Tees
+31.2 -- Section 302 Certification of
Gary L. Whitlock
+32.1 -- Section 906 Certification of
David G. Tees
+32.2 -- Section 906 Certification of
Gary L. Whitlock
+99.1 -- Items incorporated by
reference from the Texas
Genco Form 10-K:
Business--Environmental
Matters--Asbestos" in Item 1,
"Market for Common Stock and
Related Stockholder Matters"
in Item 5, "Management's
Discussion and Analysis of
Financial Condition and
Results of Operations--
Certain Factors Affecting
Future Earnings" in Item 7,
and Notes 2(f), 2(h), 6(a) and 8.
(b) Reports on Form 8-K.
On April 23, 2003, we filed a Current Report on Form 8-K dated April 16,
2003, reporting the shutdown of a reactor at the South Texas Project Nuclear
Generating Station.
On April 24, 2003, we filed a Current Report on Form 8-K dated April 24,
2003, in which we announced first quarter 2003 earnings.
On May 1, 2003, we filed a Current Report on Form 8-K dated April 24, 2003,
to furnish under Item 9 and Item 12 of that form transcripts of the earnings
conference call held on April 24, 2003.
On July 29, 2003, we filed a Current Report on Form 8-K dated July 29, 2003
in which we announced second quarter 2003 earnings.
35
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.
TEXAS GENCO HOLDINGS, INC.
By: /s/ James S. Brian
------------------------------------------
James S. Brian
Senior Vice President and Chief Accounting Officer
Date: August 13, 2003
36
EXHIBIT INDEX
The following exhibits are filed herewith:
Exhibits not incorporated by reference to a prior filing are designated by a
cross (+); all exhibits not so designated are incorporated by reference to a
prior filing as indicated.
SEC FILE
OR
EXHIBIT REGISTRATION EXHIBIT
NUMBER DESCRIPTION REPORT OR REGISTRATION STATEMENT NUMBER REFERENCE
- ------- ---------------------------- -------------------------------- ------ ---------
3.1 -- Amended and Restated Texas Genco Holdings, Inc.'s 1-31449 3.1
Articles of Incorporation ("Texas Genco") Form 10-K for
the year ended December 31, 2002
3.2 -- Amended and Restated Bylaws Texas Genco's Form 10-K for 1-31449 3.2
the year ended December 31, 2002
4.1 -- Specimen Stock Certificate Texas Genco's registration 1-31449 4.1
statement on Form 10
+10.1 -- Pledge Agreement dated as of
May 28, 2003, by Utility
Holding, LLC, in favor of JP
Morgan Chase Bank, as
administrative agent
+31.1 -- Section 302 Certification of
David G. Tees
+31.2 -- Section 302 Certification of
Gary L. Whitlock
+32.1 -- Section 906 Certification of
David G. Tees
+32.2 -- Section 906 Certification of
Gary L. Whitlock
+99.1 -- Items incorporated by
reference from the Texas
Genco Form 10-K: "Business--
Environmental Matters--
Asbestos" in Item 1, "Market
for Common Stock and Related
Stockholder Matters" in Item
5, "Management's Discussion
and Analysis of Financial
Condition and Results of
Operations-- Certain Factors
Affecting Future Earnings" in
Item 7, and Notes 2(f), 2(h),
6(a) and 8.