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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Quarterly Period Ended September 30, 2002
[ ] 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
1-10290
DQE, Inc.
(Exact name of registrant as specified in its charter)
Pennsylvania 25-1598483
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
411 Seventh Avenue
Pittsburgh, Pennsylvania 15219
(Address of principal executive offices)(Zip Code)
Registrant's telephone number, including area code: (412) 393-6000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months and (2) has been subject to such filing requirements for
the past 90 days. Yes [X] No[ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of the latest practicable date:
DQE Common Stock, no par value - 74,315,771 shares outstanding as of October 31,
2002.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
DQE Condensed Consolidated Statements of Income (Unaudited)
- -----------------------------------------------------------------------------------------------------------
(Millions of Dollars, Except Per Share Amounts)
-----------------------------------------------
Three Months Nine Months
Ended September 30, Ended September 30,
------------------- -------------------
2002 2001 2002 2001
- -----------------------------------------------------------------------------------------------------------
Operating Revenues:
Electricity sales $250.5 $291.7 $ 724.7 $788.4
Other 30.4 30.1 93.6 115.4
- -----------------------------------------------------------------------------------------------------------
Total Operating Revenues 280.9 321.8 818.3 903.8
- -----------------------------------------------------------------------------------------------------------
Operating Expenses:
Purchased power 124.3 120.4 327.2 318.0
Other operating 54.0 55.8 163.7 178.7
Maintenance 4.0 5.7 17.7 17.4
Depreciation and amortization 31.5 96.5 157.9 264.1
Taxes other than income taxes 17.5 15.7 52.5 45.4
- -----------------------------------------------------------------------------------------------------------
Total Operating Expenses 231.3 294.1 719.0 823.6
- -----------------------------------------------------------------------------------------------------------
Operating Income 49.6 27.7 99.3 80.2
- -----------------------------------------------------------------------------------------------------------
Other Income:
Investment income 16.4 33.8 55.9 63.1
Investment impairment (Note D) -- -- (10.8) (47.3)
- -----------------------------------------------------------------------------------------------------------
Total Other Income 16.4 33.8 45.1 15.8
Interest and Other Charges 19.6 24.6 63.9 80.0
- -----------------------------------------------------------------------------------------------------------
Income from Continuing Operations Before Income Taxes 46.4 36.9 80.5 16.0
Income Tax Expense 17.2 12.5 31.4 0.1
- -----------------------------------------------------------------------------------------------------------
Income from Continuing Operations 29.2 24.4 49.1 15.9
Loss from Discontinued Operations - Net (2.2) (1.7) (102.4) (102.7)
- -----------------------------------------------------------------------------------------------------------
Income (Loss) before Cumulative Effect of Change in
Accounting Principle 27.0 22.7 (53.3) (86.8)
Cumulative Effect of Change in Accounting Principle - Net -- -- (113.7) --
- -----------------------------------------------------------------------------------------------------------
Net Income (Loss) 27.0 22.7 (167.0) (86.8)
Dividends on Preferred Stock 0.2 0.2 0.5 0.4
- -----------------------------------------------------------------------------------------------------------
Earnings (Loss) Available for Common Stock $ 26.8 $ 22.5 $(167.5) $(87.2)
===========================================================================================================
Average Number of Common Shares Outstanding (Millions of
Shares) 74.1 55.9 62.6 55.9
===========================================================================================================
Basic Earnings (Loss) Per Share of Common Stock:
Earnings from Continuing Operations $ 0.39 $ 0.43 $ 0.78 $ 0.28
Loss from Discontinued Operations $(0.03) $(0.03) $ (1.64) $(1.84)
Cumulative Effect of Change in Accounting Principle $ -- $ -- $ (1.82) $ --
- -----------------------------------------------------------------------------------------------------------
Basic Earnings (Loss) Per Share of Common Stock $ 0.36 $ 0.40 $ (2.68) $(1.56)
===========================================================================================================
Diluted Earnings (Loss) Per Share of Common Stock:
Earnings from Continuing Operations $ 0.39 $ 0.43 $ 0.77 $ 0.28
Loss from Discontinued Operations $(0.03) $(0.03) $ (1.61) $(1.84)
Cumulative Effect of Change in Accounting Principle $ -- $ -- $ (1.79) $ --
- -----------------------------------------------------------------------------------------------------------
Diluted Earnings (Loss) Per Share of Common Stock $ 0.36 $ 0.40 $ (2.63) $(1.56)
===========================================================================================================
Dividends Declared Per Share of Common Stock $ 0.25 $ 0.42 $ 1.09 $ 1.26
===========================================================================================================
See notes to condensed consolidated financial statements.
2
DQE Condensed Consolidated Balance Sheets (Unaudited)
- -----------------------------------------------------------------------------------------------
(Millions of Dollars)
----------------------------
September 30, December 31,
2002 2001
- -----------------------------------------------------------------------------------------------
ASSETS
Current Assets:
Cash and temporary cash investments $ 63.8 $ 7.2
Receivables - net 156.0 166.5
Other 62.4 116.9
Discontinued operations 199.9 25.9
- -----------------------------------------------------------------------------------------------
Total Current Assets 482.1 316.5
- -----------------------------------------------------------------------------------------------
Long-Term Investments 594.3 635.5
- -----------------------------------------------------------------------------------------------
Property, Plant and Equipment 2,170.3 2,119.2
Less: Accumulated depreciation (691.3) (647.2)
- -----------------------------------------------------------------------------------------------
Total Property, Plant and Equipment - Net 1,479.0 1,472.0
- -----------------------------------------------------------------------------------------------
Other Non-Current Assets:
Transition costs 31.8 134.3
Regulatory assets 282.6 267.2
Other 37.2 46.1
Discontinued operations -- 354.3
- -----------------------------------------------------------------------------------------------
Total Other Non-Current Assets 351.6 801.9
- -----------------------------------------------------------------------------------------------
Total Assets $ 2,907.0 $ 3,225.9
===============================================================================================
CAPITALIZATION AND LIABILITIES
- -----------------------------------------------------------------------------------------------
Current Liabilities:
Notes payable and current debt maturities $ 0.8 $ 151.0
Other 221.4 216.1
Discontinued operations 54.0 19.7
- -----------------------------------------------------------------------------------------------
Total Current Liabilities 276.2 386.8
- -----------------------------------------------------------------------------------------------
Non-Current Liabilities:
Deferred income taxes - net 557.2 611.4
Deferred income 94.0 103.5
Other 138.8 169.0
Discontinued operations -- 19.9
- -----------------------------------------------------------------------------------------------
Total Non-Current Liabilities 790.0 903.8
- -----------------------------------------------------------------------------------------------
Commitments and contingencies (Note H)
- -----------------------------------------------------------------------------------------------
Capitalization:
Long-Term Debt 1,082.2 1,184.5
- -----------------------------------------------------------------------------------------------
DLC Obligated Mandatorily Redeemable Preferred Trust Securities 150.0 150.0
- -----------------------------------------------------------------------------------------------
Preferred Stock:
DQE preferred stock 16.4 16.4
Preferred stock of subsidiaries 62.1 62.1
Preference stock of subsidiaries 14.8 13.8
- -----------------------------------------------------------------------------------------------
Total Preferred Stock 93.3 92.3
- -----------------------------------------------------------------------------------------------
Common Shareholders' Equity:
Common stock - no par value (authorized - 187,500,000 shares;
issued - 126,929,154 and 109,679,154 shares) 1,219.0 994.8
Retained earnings 521.0 759.7
Treasury stock (at cost) (51,560,664 and 53,770,877 shares) (1,224.2) (1,246.7)
Accumulated other comprehensive income (0.5) 0.7
- -----------------------------------------------------------------------------------------------
Total Common Shareholders' Equity 515.3 508.5
- -----------------------------------------------------------------------------------------------
Total Capitalization 1,840.8 1,935.3
- -----------------------------------------------------------------------------------------------
Total Liabilities and Capitalization $ 2,907.0 $ 3,225.9
===============================================================================================
See notes to condensed consolidated financial statements.
3
DQE Condensed Consolidated Statements of Cash Flows (Unaudited)
- ------------------------------------------------------------------------------------------------
(Millions of Dollars)
-------------------------------
Nine Months Ended September 30,
-------------------------------
2002 2001
- ------------------------------------------------------------------------------------------------
Cash Flows From Operating Activities:
Operations $ 14.9 $ 136.0
Cumulative effect of change in
accounting principle, net 113.7 --
Changes in working capital other than cash (22.8) (4.2)
Cash flows from discontinued operations 87.2 52.8
Other (0.4) (3.5)
- ------------------------------------------------------------------------------------------------
Net Cash Provided from Operating Activities 192.6 181.1
- ------------------------------------------------------------------------------------------------
Cash Flows From Investing Activities:
Capital expenditures (60.4) (85.2)
Proceeds from disposition of investments 21.1 45.8
Collection of note receivable 7.0 --
Other (2.3) (13.7)
- ------------------------------------------------------------------------------------------------
Net Cash Used in Investing Activities (34.6) (53.1)
- ------------------------------------------------------------------------------------------------
Cash Flows From Financing Activities:
Issuance of debt (Note G) 300.0 --
Reductions of long-term obligations (Note G) (553.0) (65.3)
Issuance of common stock 223.4 --
Dividends on common and preferred stock (71.5) (70.8)
Other (0.3) 5.5
- ------------------------------------------------------------------------------------------------
Net Cash Used in Financing Activities (101.4) (130.6)
- ------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and temporary cash investments 56.6 (2.6)
Cash and temporary cash investments at beginning of period 7.2 15.8
- ------------------------------------------------------------------------------------------------
Cash and temporary cash investments at end of period $ 63.8 $ 13.2
================================================================================================
See notes to condensed consolidated financial statements.
DQE Condensed Consolidated Statements of Comprehensive Income (Unaudited)
- ---------------------------------------------------------------------------------------------------
(Millions of Dollars)
-----------------------------------------
Three Months Nine Months
Ended September 30, Ended September 30,
-----------------------------------------
2002 2001 2002 2001
- ---------------------------------------------------------------------------------------------------
Net income (loss) $27.0 $ 22.7 $(167.0) $ (86.8)
- ---------------------------------------------------------------------------------------------------
Other comprehensive income:
Unrealized holding losses arising during the period,
net of tax of $(0.3), $(11.4), $(0.3) and $(14.6) (0.5) (21.2) (0.5) (27.1)
Reclassification adjustment for
realized holding loss -- -- (0.7) --
- ---------------------------------------------------------------------------------------------------
Comprehensive Income (Loss) $26.5 $ 1.5 $(168.2) $(113.9)
===================================================================================================
See notes to condensed consolidated financial statements.
4
Notes to Condensed Consolidated Financial Statements (Unaudited)
A. CONSOLIDATION AND ACCOUNTING POLICIES
Consolidation
DQE, Inc. delivers essential products and related services, including
electricity, water and communications, to more than one million customers
throughout the United States. Our subsidiaries include Duquesne Light Company;
AquaSource, Inc.; DQE Energy Services, LLC; Duquesne Power, Inc.; DQE Financial
Corp.; DQE Enterprises, Inc.; DQE Communications, Inc.; ProAm, Inc.; Cherrington
Insurance, Ltd.; and DQE Capital Corporation.
Duquesne Light, our largest operating subsidiary, is an electric utility
engaged in the transmission and distribution of electric energy.
AquaSource is a water resource management company. Since July 2002, we have
entered into agreements to sell more than 85% of AquaSource's assets. AquaSource
is now reported as a discontinued operation. (See Note I.)
DQE Energy Services is an energy facilities management company that
provides energy outsourcing solutions including development, operation and
maintenance of energy and alternative fuel facilities.
Duquesne Power was formed in April 2002 to explore various alternative
generation supply options.
DQE Financial owns and operates landfill gas collection and processing
systems, and is an investment and portfolio management organization focused on
structured finance and alternative energy investments.
DQE Capital, a 100%-owned finance subsidiary, provides financing for the
operations of our subsidiaries other than Duquesne Light. We fully and
unconditionally guarantee payment of DQE Capital's debt securities including
$100.0 million of Public Income Notes, due 2039, and a $140.0 million revolving
credit facility. At September 30, 2002 no borrowings were outstanding under the
credit facility.
DQE Enterprises manages our remaining electronic commerce and energy
technologies investment portfolios.
Our other business lines include the following: propane distribution,
communications systems, and insurance services for DQE and various affiliates.
The consolidated financial statements include the accounts of DQE and our
wholly and majority owned subsidiaries. The equity method of accounting is used
when we have a 20 to 50% interest in other companies. Under the equity method,
original investments are recorded at cost and adjusted by our share of
undistributed earnings or losses of these companies. All material intercompany
balances and transactions have been eliminated in the consolidation.
Basis of Accounting
DQE and Duquesne Light are subject to the accounting and reporting
requirements of the Securities and Exchange Commission (SEC). Duquesne Light's
electricity delivery business is also subject to regulation by the Pennsylvania
Public Utility Commission (PUC) and the Federal Energy Regulatory Commission
(FERC) with respect to rates for delivery of electric power, accounting and
other matters.
As a result of our PUC-approved restructuring plan, the electricity supply
segment does not meet the criteria of Statement of Financial Accounting
Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of
Regulation." Pursuant to the PUC's final restructuring order, and as provided in
the Pennsylvania Electricity Generation Customer Choice and Competition Act
(Customer Choice Act), generation-related transition costs are being recovered
through a competitive transition charge (CTC) collected in connection with
providing transmission and distribution services, and these assets have been
reclassified accordingly. The electricity delivery business segment continues to
meet SFAS No. 71 criteria, and accordingly reflects regulatory assets and
liabilities consistent with cost-based ratemaking regulations. The regulatory
assets represent probable future revenue, because provisions for these costs are
currently included, or are expected to be included, in charges to electric
utility customers through the ratemaking process. (See Note B.)
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires us to
make estimates and assumptions with respect to values and conditions that affect
the reported amounts of assets and liabilities, and disclosure of contingent
assets and liabilities, at the date of the financial statements. The reported
amounts of revenues and expenses during the reporting period also may be
affected by the
5
estimates and assumptions we are required to make. We evaluate these estimates
on an ongoing basis, using historical experience, consultation with experts and
other methods we consider reasonable in the particular circumstances.
Nevertheless, actual results may differ significantly from our estimates.
The interim financial information for the three and nine month periods
ended September 30, 2002 is unaudited and has been prepared on the same basis as
the audited financial statements. In the opinion of management, such unaudited
information includes all adjustments (consisting only of normal recurring
adjustments) necessary for a fair presentation of the interim information. This
information does not include all footnotes which would be required for complete
annual financial statements in accordance with accounting principles generally
accepted in the United States of America.
These statements should be read with the financial statements and notes
included in our Annual Report on Form 10-K for the year ended December 31, 2001
filed with the SEC. The results of operations for the three and nine months
ended September 30, 2002, are not necessarily indicative of the results that may
be expected for the full year.
Earnings Per Share
Basic earnings per share are computed on the basis of the weighted average
number of common shares outstanding. Diluted earnings per share are computed on
the basis of the weighted average number of common shares outstanding, plus the
effect of the outstanding Employee Stock Ownership Plan shares, DQE preferred
stock and stock options, unless a loss from continuing operations occurs as the
inclusion of these shares would be anti-dilutive. The treasury stock method is
used in computing the dilutive effect of stock options. This method assumes any
proceeds obtained upon the exercise of options would be used to purchase common
stock at the average market price during the period. The following table
presents the numerators and denominators used in computing the diluted earnings
per share for the nine months ended September 30, 2002 and September 30, 2001.
Diluted Earnings (Loss) Per Share
For the Nine Months Ended September 30,
- -----------------------------------------------------
(Millions of Dollars) 2002 2001
- -----------------------------------------------------
Income from continuing operations $49.1 $15.9
Less: Preferred dividends (0.5) (0.4)
- -----------------------------------------------------
Income from continuing operations for
basic EPS 48.6 15.5
Dilutive effect of:
ESOP dividends -- --
Preferred stock dividends 0.5 --
- -----------------------------------------------------
Diluted Earnings from Continuing
Operations for Common $49.1 $15.5
=====================================================
- -----------------------------------------------------
(Millions of Shares) 2002 2001
- -----------------------------------------------------
Basic average shares 62.6 55.9
Dilutive effect of:
ESOP shares -- --
DQE preferred stock 0.9 --
Stock options -- --
- -----------------------------------------------------
Diluted average shares 63.5 55.9
- -----------------------------------------------------
Diluted Earnings Per Share from
Continuing Operations $0.77 $0.28
=====================================================
Recent Accounting Pronouncements
On January 1, 2002, we adopted SFAS No. 141, "Business Combinations," and
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets,"
the impact of which was not significant to our financial statements.
In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 143, "Accounting for Asset Retirement Obligations," which addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. Specifically, this standard requires entities to record the fair value of
a liability for an asset retirement obligation in the period in which it is
incurred, if a reasonable estimate of fair value can be made. The entity is
required to capitalize the cost by increasing the carrying amount of the related
long-lived asset. The capitalized cost is then depreciated over the useful life
of the related asset. Upon settlement of the liability, an entity either settles
the obligation for its recorded amount or incurs a gain or loss.
6
The standard is effective for fiscal years beginning after June 15, 2002. We are
currently evaluating, but have yet to determine, the impact that the adoption of
SFAS No. 143 will have on our financial statements.
Reclassification
The 2001 condensed consolidated financial statements have been reclassified
to conform with the 2002 presentation.
B. RATE MATTERS
Competition and the Customer Choice Act
The Customer Choice Act enables electric utility customers to purchase
electricity at market prices from a variety of electric generation suppliers. As
of September 30, 2002, approximately 76.6% of Duquesne Light's customers
measured on a kilowatt-hour (KWH) basis and approximately 75.6% on a
non-coincident peak load basis received electricity through our provider of last
resort service arrangement (discussed below). The remaining customers are
provided with electricity through alternative generation suppliers. The number
of customers participating in our provider of last resort service will fluctuate
depending on market prices and the number of alternative generation suppliers in
the retail supply business.
Customers who select an alternative generation supplier pay for generation
charges set competitively by that supplier, and pay Duquesne Light CTC
(discussed below) and/or transmission and distribution charges. Electricity
delivery (including transmission, distribution and customer service) remains
regulated in substantially the same manner as under historical regulation.
In November 2001, the Pennsylvania Department of Revenue established an
increased revenue neutral reconciliation tax (RNR) in order to recover a current
shortfall that resulted from electricity generation deregulation. Duquesne Light
requested and received PUC approval to recover approximately $13 million of
costs it will incur in 2002 due to the RNR.
Regional Transmission Organization
FERC Order No. 2000 calls on transmission-owning utilities such as Duquesne
Light to join regional transmission organizations (RTOs). Duquesne Light is
committed to ensuring a stable, plentiful supply of electricity for its
customers. Toward that end, Duquesne Light had planned to join the PJM West RTO.
However, on July 31, 2002, the FERC issued a series of proposals designed to
establish a standard market design and transmission service for interstate
electricity transactions, and extend the deadline for joining an RTO until
September 2004. Duquesne Light will continue to evaluate the FERC's proposals
and their impact on the possibility of joining an RTO.
Competitive Transition Charge
In its final restructuring order, the PUC determined that Duquesne Light
should recover most of the above-market costs of its generation assets,
including plant and regulatory assets, through the collection of the CTC from
electric utility customers. As of September 30, 2002, the CTC balance has been
fully collected for approximately 95% of Duquesne Light's customers, and 87% of
the KWH sales for the first nine months of 2002. The transition costs, as
reflected on the consolidated balance sheet, are being amortized over the same
period that the CTC revenues are being recognized.
For regulatory purposes, the unrecovered balance of transition costs was
approximately $32.6 million ($19.8 million net of tax) at September 30, 2002, on
which Duquesne Light is allowed to earn an 11% pre-tax return. A lower amount is
shown on the balance sheet due to the accounting for unbilled revenues.
Provider of Last Resort
Although no longer a generation supplier, as the provider of last resort
for all customers in its service territory, Duquesne Light must provide
electricity for any customer who does not choose an alternative generation
supplier, or whose supplier fails to deliver. As part of the generation asset
sale, a third party agreed to supply all of the electric energy necessary to
satisfy Duquesne Light's provider of last resort obligations during the CTC
collection period. Duquesne Light has extended the arrangement (and the
PUC-approved rates for the supply of electricity) beyond the final CTC
collection through December 31, 2004 (POLR II). The agreement also permits
Duquesne Light, following CTC collection for each rate class, an average margin
of 0.5 cents per KWH supplied through this arrangement. Except for this margin,
these agreements, in general, effectively transfer to the supplier the financial
risks and rewards associated with Duquesne Light's provider of last resort
obligations.
While there are certain safeguards in the provider of last resort
arrangements designed to mitigate losses in the event that the supplier defaults
on its performance under the arrangement, Duquesne Light may face the credit
risk of such a default. Contractually, Duquesne Light has various credit
enhancements that would become activated upon certain events. If the supplier
were to fail to deliver, Duquesne Light
7
would have to contract with another supplier and/or make purchases in the market
at the time of default at a time when market prices could be higher. While the
Customer Choice Act provides generally for provider of last resort supply costs
to be borne by customers, recent litigation suggests that it may not be clear
whether Duquesne Light could pass any costs in excess of the existing
PUC-approved provider of last resort prices on to its customers. Additionally,
the supplier has recently been downgraded by the rating agencies. Although we
are following the situation closely, our knowledge is limited to public
disclosure, and we do not know whether the downgrade could affect the supplier's
ability to perform. Duquesne Light also retains the risk that customers will not
pay for the provider of last resort generation supply. However, a component of
Duquesne Light's delivery rate is designed to cover the cost of a normal level
of uncollectible accounts.
On October 25, 2002, Duquesne Light petitioned the PUC to issue a
declaratory order regarding a provision in its retail tariff that affects its
largest industrial customer. The supplier and Duquesne Light have interpreted
the tariff differently. The supplier's interpretation could increase the
customer's bill by approximately $7 to $9 million annually. Duquesne Light has
requested that the PUC affirm Duquesne Light's interpretation of the tariff
requirements. Duquesne Light retains the risk of recovering this increase from
the customer, should the customer refuse to pay. This risk is not included in
the "normal level" of uncollectible accounts described above.
Rate Freeze
In connection with POLR II, Duquesne Light negotiated a rate freeze for
generation, transmission and distribution rates. The rate freeze fixes new
generation rates through 2004 for retail customers who take electricity under
POLR II, and continues the transmission and distribution rates for all customers
at current levels through at least 2003. Under certain circumstances, affected
interests may file a complaint alleging that, under these frozen rates, Duquesne
Light has exceeded reasonable earnings, in which case the PUC could make
adjustments to rectify such earnings.
C. RECEIVABLES
The components of receivables for the periods indicated are as follows:
- ----------------------------------------------------------------------------
(Millions of Dollars)
----------------------------
September 30, December 31,
2002 2001
- ----------------------------------------------------------------------------
Electric customers $100.5 $ 97.1
Unbilled revenue accrual 31.3 36.6
Other utility 3.4 3.2
Other 29.3 36.2
Less: Allowance for uncollectible accounts (8.5) (6.6)
- ----------------------------------------------------------------------------
Total $156.0 $166.5
============================================================================
D. IMPAIRMENT CHARGES
Goodwill
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets," which establishes financial accounting and reporting for acquired
goodwill and other intangible assets. This standard requires that goodwill and
intangible assets with indefinite useful lives not be amortized but, instead, be
tested at least annually for impairment, and more frequently if certain
indicators appear. We adopted this standard effective January 1, 2002, and
accordingly ceased amortization of goodwill, our only intangible asset with an
indefinite useful life.
The required test for impairment consists of a two-step process that begins
with an estimation of the fair value of our reporting units. The first step is a
screen for potential impairment and the second measures the amount of
impairment, if any. The new standard requires that we complete the first step of
the goodwill impairment test by June 30, 2002. To the extent that an indication
of impairment exists upon completion of the first step, we must perform a second
test to measure the amount of the impairment. The second test must be performed
as soon as possible, but no later than December 31, 2002. However, if the second
step of the goodwill impairment test is not complete, but a goodwill impairment
loss is probable and can be reasonably estimated, the best estimate of that loss
shall be recognized. Any impairment measured as of the date of adoption will be
recognized as the cumulative effect of a change in accounting principle.
Our goodwill relates to both our water resource management and propane
delivery businesses. Beginning in the third quarter of 2002, our water resource
management business is treated as a discontinued operation. (See Note I.) Our
propane delivery business is included in our all other category.
We had independent valuations performed on both of these reporting units in
order to determine their fair values as of January 1, 2002. These valuations
determined the implied fair values of each of the reporting units using a
discounted cash flow analysis and public company trading multiples. These
valuations indicated that the fair values of both reporting units were less than
their carrying values, an indication of impairment. We then assessed the fair
value of the tangible assets and liabilities of each of these reporting units,
and determined that substantially all of the goodwill related to the water
distribution reporting unit and a portion of the goodwill related to the propane
8
delivery reporting unit was impaired as of January 1, 2002. The valuation of the
water distribution reporting unit was further supported by the terms of the July
29, 2002 agreement to sell approximately 85% of AquaSource's 2001 total assets,
for a purchase price that was significantly less than the carrying amount of the
reporting unit. Accordingly, we recognized a $113.7 million charge, recorded as
of January 1, 2002, as the cumulative effect of a change in accounting principle
for the write-down of goodwill to its fair value, consisting of $103.0 million
related to water distribution and $10.7 million related to propane delivery. The
impaired goodwill was not deductible for tax purposes, and as a result, no tax
benefit was recorded in relation to the charge.
Total goodwill of $20.7 million remains, principally at the propane
delivery reporting unit ($19.8 million).
The following table reconciles the prior year's reported net income/loss
and earnings/loss per share, adjusted to exclude goodwill amortization expense
that is no longer recorded under the provisions of SFAS No. 142.
- --------------------------------------------------------------------------
Three Months Ended
-----------------------------
September 30, September 30,
2002 2001
- --------------------------------------------------------------------------
Reported net income $27.0 $22.7
Goodwill amortization - water distribution -- 0.7
Goodwill amortization - propane delivery -- 0.3
- --------------------------------------------------------------------------
Adjusted net income $27.0 $23.7
==========================================================================
Basic and diluted earnings per share:
Reported $0.36 $0.40
Adjusted $0.36 $0.42
- --------------------------------------------------------------------------
- --------------------------------------------------------------------------
Nine Months Ended
-----------------------------
September 30, September 30,
2002 2001
- --------------------------------------------------------------------------
Reported net loss $(167.0) $(86.8)
Goodwill amortization - water distribution -- 3.6
Goodwill amortization - propane delivery -- 0.9
- --------------------------------------------------------------------------
Adjusted net loss $(167.0) $(82.3)
==========================================================================
Basic loss per share:
Reported $ (2.68) $(1.56)
Adjusted $ (2.68) $(1.48)
- --------------------------------------------------------------------------
Diluted loss per share:
Reported $ (2.63) $(1.56)
Adjusted $ (2.63) $(1.48)
- --------------------------------------------------------------------------
AquaSource
In May 2002, we indicated that we were exploring the sale of our water
resource management business. In late June 2002, we received indications of
interest for this business, and ultimately determined that the likely outcome
would be a sale of this business. Based on the information received, an
indication of impairment of long-lived assets existed.
We estimated the proceeds to be received from a sale and compared them to
the carrying amount of the long-lived assets that remained after the goodwill
impairment, described above. This comparison indicated that the carrying amount
of the investor-owned water and wastewater utilities to be sold significantly
exceeded the expected proceeds to be received. As a result, we recorded an
impairment charge of $100.9 million in the second quarter of 2002, which reduced
the amount of property, plant and equipment and other long-lived assets; this
charge is reflected in discontinued operations. No tax benefit was recognized in
connection with this impairment charge due to the uncertainty of the
recoverability of the resulting deferred tax asset.
During 2001, our management team evaluated AquaSource's future direction
and the capabilities of its operating platforms. This evaluation determined that
the company's potential future performance would result in lower returns than
originally anticipated. AquaSource therefore recorded a second quarter 2001
pre-tax impairment charge of $109.2 million, or $99.7 million after tax, to
write down various aspects of its business, primarily related to contract
operations and construction. The assets determined to be impaired consisted of
goodwill, property, plant and equipment, and other assets. This charge is
reflected in discontinued operations.
We determined the value of the impairments by projecting the undiscounted
future cash flows generated by the specific assets over the assets' expected
lives. To the extent that the undiscounted future cash flows did not exceed the
book carrying value of the assets, the future cash flows were discounted back at
our cost of borrowing to determine the carrying value of the assets. The
impairment charge recorded is the difference between the previous book carrying
value and the carrying value determined by this process.
9
DQE Enterprises
During the second quarter of 2002, DQE Enterprises wrote down three
investments in publicly traded applied technology businesses to their quoted
market value as of the balance sheet date, and recognized the associated
impairment charge of $10.0 million. This charge reflects an other-than-temporary
decline in the market value of the underlying securities. Enterprises also
recorded a $0.8 million impairment charge for the write-off of two investments
in privately-held entities which have filed for protection under Chapter 7 of
the U.S. Bankruptcy Code.
During the second quarter of 2001, Enterprises sold two investments and
recognized an impairment charge to write off all or parts of seven other
investments, resulting in a pre-tax charge of $47.3 million, or $27.7 million
after tax. We determined the value of the impairment of each of these
investments by analyzing their business prospects. This analysis included an
evaluation of the business' cash on-hand, its fundraising abilities, its number
of customers and contracts, and its overall ability to continue as a going
concern. In addition, we obtained an independent external valuation for certain
of the businesses.
E. RESTRUCTURING CHARGES
During the fourth quarter of 2001, we recorded a pre-tax restructuring
charge of $31.1 million. The restructuring plan included the (1) consolidation
and reduction of certain administrative and back-office functions through an
involuntary termination plan; (2) abandonment of certain office facilities to
relocate employees to one centralized location; and (3) write-off of certain
leasehold improvements related to abandoned office facilities. Of the $31.1
million, $20.1 million was for employee termination benefits for approximately
200 management, professional and administrative personnel; $8.0 million was for
future lease payments; and $3.0 million was for other lease costs associated
with the restructuring plan. To date, approximately 160 employees have been
terminated. The restructuring liability at September 30, 2002 was $12.7 million
and is included in "other current liabilities" on the condensed consolidated
balance sheet.
The following table summarizes the current year activity for the accrued
restructuring liability for the period ended September 30, 2002:
- ----------------------------------------------------------------
Restructuring Liability
-----------------------------
(Millions of Dollars)
-----------------------------
Employee
Termination Lease
Benefits Costs Total
- ----------------------------------------------------------------
Balance at December 31, 2001 $15.8 $ 8.7 $ 24.5
2002 payments (9.6) (2.2) (11.8)
- ----------------------------------------------------------------
Balance at September 30, 2002 $ 6.2 $ 6.5 $ 12.7
================================================================
We believe that the remaining provision is adequate to complete the
restructuring plan. We expect the remaining restructuring liabilities to be paid
on a monthly basis throughout 2006.
F. COMMON STOCK OFFERING
On June 26, 2002 we issued 17,250,000 shares of common stock at $13.50 per
share in an underwritten public offering. We received net proceeds, after
payment of underwriters discounts and commissions and other expenses, of $223.4
million.
G. DEBT
In September 2002, Duquesne Light converted approximately $98 million of
variable rate debt to fixed rate with maturities in 2011 and 2013, resulting in
a weighted average interest rate of 4.20%.
On August 5, 2002, we redeemed the following: (i) $10 million aggregate
principal amount of Duquesne Light's 8.20% first mortgage bonds due 2022 at a
redemption price of 104.51% of the principal amount thereof, and (ii) $100
million aggregate principal amount of Duquesne Light's 7 5/8% first mortgage
bonds due 2023 at a redemption price of 103.9458% of the principal amount
thereof.
On April 15, 2002, Duquesne Light issued $200 million of 6.7% first
mortgage bonds due 2012. On April 30, 2002, Duquesne Light issued $100 million
of 6.7% first mortgage bonds due 2032. In each case it used the proceeds to call
and refund existing debt, including debt scheduled to mature in 2003 and 2004.
10
H. COMMITMENTS AND CONTINGENCIES
Construction
We estimate that in 2002 we will spend, excluding the allowance for funds
used during construction, approximately $70 million for electric utility
construction; $53 million for water utility construction (now included in
discontinued operations, as discussed in Note I); and $10 million for
construction by our other business lines.
Guarantees
As part of our investment portfolio in affordable housing, we have received
fees in exchange for guaranteeing a minimum defined yield to third-party
investors. The original amount guaranteed was approximately $250 million, and
has declined as investors have earned the guaranteed returns. In addition, we
have paid for a partial release from certain guaranteed investors. The remaining
amount of such guarantees at September 30, 2002, was $74.5 million (assuming the
favorable tax treatment accorded these investments continues). A portion of the
fees received has been deferred to absorb any required payments with respect to
these transactions. Based on an evaluation of and recent experience with the
underlying housing projects, we believe that such deferrals are sufficient for
this purpose.
Employees
Duquesne Light is a party to a labor contract with the International
Brotherhood of Electrical Workers (IBEW), which represents the majority of
Duquesne Light's employees. This contract expires September 30, 2003.
Legal Proceedings
AquaSource. In February 2001, 39 former and current employees of our
subsidiary AquaSource, Inc., all minority investors in AquaSource, commenced an
action against DQE, AquaSource and others in the District Court of Harris
County, Texas. The complaint alleged that the defendants fraudulently induced
the plaintiffs to agree to sell their AquaSource Class B stock back to
AquaSource by falsely promising orally that DQE would invest $1 billion or more
in AquaSource, which, plaintiffs allege, would have permitted them to realize
significant returns on their investments in AquaSource. The complaint also
alleged that the defendants mismanaged AquaSource, and thus decreased the value
of plaintiffs' AquaSource stock.
Plaintiffs sought, among other relief, an order rescinding their agreements
to sell their stock back to AquaSource, an award of actual damages not to exceed
$100 million and exemplary damages not to exceed $400 million.
In the first quarter of 2002, DQE and AquaSource filed counterclaims
alleging that 10 plaintiffs who held key AquaSource management positions engaged
in deceptive practices designed to obtain funding for acquisitions and to make
those acquisitions appear to meet certain return on investment requirements, and
that all plaintiffs were unjustly enriched by these wrongful actions. DQE,
AquaSource and AquaSource Utility, Inc. also filed a counterclaim against two
plaintiffs alleging claims for breach of contract, breach of warranty,
indemnification, fraud and unjust enrichment in connection with the acquisition
of various water and wastewater companies from these two plaintiffs.
The parties entered into a settlement agreement which became effective
October 7, 2002. The total settlement is valued at approximately $22 million,
and includes cash, 60,000 shares of our Preferred Stock, Series A (Convertible),
a note receivable, an AquaSource building in Houston together with furniture and
fixtures, and one other piece of real property in Houston. The building,
furniture, fixtures and property were transferred to the plaintiffs' designee.
The plaintiffs provided all defendants with a broad release of all claims
arising out of the transactions that are the subject of the litigation, as well
as all claims relating to any plaintiff's past employment with AquaSource. The
plaintiffs also agreed not to solicit AquaSource customers or employees through
October 31, 2003.
The settlement provides that each holder of the preferred stock received in
the settlement has the option to sell all, but not less than all, of such
holder's shares of the preferred stock to us on the earlier to occur of (i) a
sale by us of all or substantially all of the stock or assets of AquaSource or
(ii) the two-year anniversary of the settlement effective date. The purchase
price of each share of preferred stock to be so purchased by us will be the $100
liquidation value, plus an amount equal to accrued dividends to the date of
payment. The purchase price will be payable entirely in cash or, at our
election, in common stock.
An estimated reserve for this matter was made at June 30, 2002. The final
settlement did not significantly affect our third quarter results of operations
or cash flows.
11
Shareholder Class Action. In October and November 2001, a number of
putative class action lawsuits were filed by purported shareholders of DQE
against DQE and David Marshall, DQE's former chairman, chief executive officer
and president, in the United States District Court for the Western District of
Pennsylvania. These cases were consolidated under the caption In re DQE, Inc.
Securities Litigation, Master File No. 01-1851 (W.D. Pa.), and the plaintiffs
filed a second consolidated amended complaint on April 15, 2002. The complaint
alleges violations of Section 10(b) of the Securities Exchange Act of 1934 (the
"Exchange Act") and Rule 10b-5 promulgated thereunder, and Section 12(a)(2) of
the Securities Act of 1933 (the "Securities Act"). The complaint also alleges
controlling person liability under Section 20(a) of the Exchange Act and Section
15 of the Securities Act. The complaint alleges that between December 6, 2000
and April 30, 2001, the defendants issued a number of materially false and
misleading statements concerning investments made by our subsidiary, DQE
Enterprises, and the impact that these investments would have on our current and
future financial results.
More particularly, the complaint alleges that DQE and Marshall stated their
expectation that certain companies in which DQE Enterprises had invested would
undertake initial public offerings of their shares, with the result that our
earnings would be positively impacted by the public market valuation of DQE
Enterprises' interests in these companies, but failed to disclose allegedly
adverse facts that made the possibility of successful public offerings of the
securities of these companies unlikely. The complaint seeks an award of
unspecified compensatory damages, and an order permitting class members who
purchased DQE shares through a dividend reinvestment plan to rescind those
purchases, pre- and post-judgment interest, attorneys' fees and expenses of
litigation and unspecified equitable and injunctive relief.
On May 24, 2002, we filed a motion on behalf of DQE and David Marshall,
seeking dismissal of the lawsuit. On October 17, 2002, the District Court denied
the motion.
Although we cannot predict the ultimate outcome of this case or estimate
the range of any potential loss that may be incurred in the litigation, we
believe that the lawsuit is without merit, strenuously deny all of the
plaintiffs' allegations of wrongdoing and believe we have meritorious defenses
to the plaintiffs' claims. We are vigorously defending this lawsuit.
Income Taxes
The annual Federal corporate income tax returns have been audited by the
Internal Revenue Service (IRS) and are closed for the tax years through 1993.
The IRS examination of the 1994 tax year has been completed, and the IRS issued
a notice of proposed adjustment increasing our 1994 income tax liability in the
approximate amount of $22 million (including penalties and interest).
The proposed adjustment relates to an investment by one of our subsidiaries
in certain structured lease transactions. We have paid the proposed adjustment
and filed a protest, which is currently pending with the IRS Appeals Office. As
part of their current audit of our 1995 through 1997 years, the IRS has
indicated that it is considering proposed adjustments for these years relating
to the same transactions as well as to other similar transactions. If the IRS
were to propose adjustments relating to these transactions for the years 1995
through 2001 similar to those proposed for 1994 and if those adjustments were
sustained, we would project that the proposed assessment of additional tax would
be approximately $175 million (before interest and penalties), including the tax
portion of the $22 million adjustment for 1994. We intend to deposit $105
million with the IRS to be applied toward any adjustments which may ultimately
be proposed. The tax years 1998 through 2001 remain subject to IRS review.
One of our subsidiaries entered into other structured lease transactions
from 1995 through 1997. In 1999, the IRS published a revenue ruling setting
forth its official position which is to disallow deductions attributable to
certain leasing transactions. In October 2002, the IRS published a revenue
ruling reaffirming its position to disallow deductions attributable to leasing
transactions. We believe the IRS is likely to challenge our subsidiary's
structured lease transactions by characterizing them as those described in the
revenue ruling. However, the IRS has not yet proposed any adjustments with
respect to these transactions, and we cannot predict the nature, extent or
timing of any proposed adjustments.
It is not possible to predict if, when or to what extent any IRS
adjustments ultimately proposed for the period 1994 through 2001 will be
sustained. We do not believe that the ultimate resolution of our federal tax
liability for this period will have a material adverse effect on our financial
position. However, the resolution of this tax liability, depending on the extent
and timing thereof, could have a material adverse effect on our results of
operations and cash flows for the period in which the liability is determined or
paid.
12
Other
DQE Financial maintains a limited partnership investment in a
waste-to-energy facility. In January 2002, Moody's Investor Service downgraded
the credit rating of the general partner's parent, who also guaranteed the
partnership's obligations. This credit condition led to an event of default
under the partnership's service agreement to operate the underlying
waste-to-energy facility for a local authority. On April 1, 2002, the general
partner, its parent and the partnership filed for bankruptcy protection under
Chapter 11 of the U.S. Bankruptcy Code. The local authority issued a notice to
terminate the service agreement; however, the termination has been suspended
under the automatic stay protection afforded the partnership by the bankruptcy
filing. Subsequent to the bankruptcy filing, the general partner obtained
debtor-in-possession financing to meet ongoing cash needs and has obtained a
non-binding letter of intent to be acquired upon emergence from Chapter 11. The
partnership group, including DQE Financial, is negotiating with the local
authority to restructure the service agreement. DQE Financial is currently
assessing the effect of these events on the recoverability of its asset carrying
value, which is approximately $15.6 million as of September 30, 2002, but cannot
predict the extent of any potential charge at this time.
DQE Financial has a twenty-year lease for the gas rights to New York City's
Fresh Kills landfill. DQE Financial also maintains an investment in a gas
processing facility at the landfill and was constructing additional processing
capacity when the World Trade Center tragedy occurred. The debris from the World
Trade Center was transported to the Fresh Kills landfill and currently rests on
top of the landfill's largest hill. Landfill gas volumes have declined
substantially at the landfill due to, among other reasons, the excess weight of
the debris causing damage to the gas collection system. The decline in gas
volumes caused DQE Financial to suspend its construction of additional
processing capacity. At December 31, 2001, management determined that the Fresh
Kills investment was impaired, and recognized an impairment charge of $45.7
million on a pre-tax basis.
During 2002, DQE Financial has realized further reductions in available gas
volumes. Management is continuing discussions with the New York City Department
of Sanitation in order to improve financial performance of the facility. DQE
Financial continues to assess the effect of these events on the recoverability
of its asset carrying value, which is approximately $28.4 million as of
September 30, 2002, but cannot predict the extent of any potential charge at
this time.
I. DISCONTINUED OPERATIONS
Beginning in the third quarter of 2002, AquaSource and certain items from
the "all other" category that are associated with AquaSource have been reflected
as discontinued operations in the consolidated financial statements. These
statements have been reclassified to conform to the discontinued operations
presentation for all periods presented.
On July 29, 2002, we entered into an agreement to sell AquaSource's
investor-owned water utilities to Philadelphia Suburban Corporation (PSC) for
approximately $205 million in cash. In addition, PSC is acquiring selected
operating and maintenance contract operations in seven states that are closely
integrated with the investor-owned water utilities being acquired. The
businesses being acquired represent approximately 85% of AquaSource's 2001 total
assets. The final purchase price could vary from $180 to $215 million, as
various purchase price adjustments are applied. These adjustments relate to the
achievement of specific operating performance metrics during the interim period
until closing, involving revenue, rate base and customer connections. The
closing is expected to occur in the second half of 2003, contingent upon
regulatory approvals.
On August 5, 2002, we announced the sale of an AquaSource water utility
subsidiary to California Water Services Group for $7.7 million. This sale was
contemplated as an option under our agreement with PSC, and a purchase price
adjustment (in addition to those discussed above) will be applied with respect
to the assets to be acquired by PSC. The closing is expected to occur in early
2003, contingent upon regulatory approval.
On September 17, 2002, we announced the sale of the majority of
AquaSource's contract operations business to Southwest Water Company, for an
expected purchase price, after adjustments, to exceed $10 million in cash, which
approximates book value. The portions of the business being acquired have
operations primarily in and around Houston, Texas, and the Colorado region.
These operations represent approximately 20% of AquaSource's 2001 total revenues
and less than 2% of the company's 2001 assets. These contract operations provide
operating, maintenance, and management services to state, county, municipal, and
industrial water and
13
wastewater systems. The closing is expected to occur during the fourth quarter
of 2002.
In the first nine months of 2002, we sold various assets, including several
other wastewater facilities and real property, receiving proceeds of
approximately $6 million, which approximated book value. We are in the process
of disposing of the remainder of AquaSource's assets, which primarily includes
the construction business.
The following table summarizes income statement data from discontinued
operations:
===================================================
Three Months Ended
September 30,
------------------
(In Millions) 2002 2001
- ---------------------------------------------------
Revenues $28.5 $29.6
Operating Results, net of
tax of $1.6 and $0.2 4.0 (1.7)
Loss from sale of Discontinued
Operations, net of tax of
$(3.4) and $-- (6.2) --
- ---------------------------------------------------
===================================================
Nine Months Ended
September 30,
------------------
(In Millions) 2002 2001
- ---------------------------------------------------
Revenues $ 82.4 $ 81.6
Operating Results, net of
tax of $1.8 and $8.7 4.7 (102.7)
Loss from sale of Discontinued
Operations, net of tax of
$(3.4) and $-- (107.1) --
- ---------------------------------------------------
The following table summarizes major assets and liabilities for
discontinued operations:
========================================================
September 30, December 31,
(In Millions) 2002 2001
- --------------------------------------------------------
Other current assets $ 42.4 $ 25.9
Property and equipment,
net 157.5 216.4
Other non-current assets -- 137.9
Other current liabilities 40.6 19.7
Debt 13.4 14.3
Other non-current
liabilities -- 5.6
- --------------------------------------------------------
AquaSource currently provides water utility service to more than 520,000
water and wastewater customer connections in 18 states. AquaSource's water
utility operations are regulated by various authorities in the states where they
operate as to rates, accounting and other matters.
J. BUSINESS SEGMENTS AND RELATED INFORMATION
We report the results of our business segments, determined by products,
services and regulatory environment as follows: (1) Duquesne Light's
transmission and distribution of electricity (electricity delivery business
segment), (2) Duquesne Light's supply of electricity (electricity supply
business segment), (3) Duquesne Light's collection of transition costs (CTC
business segment), (4) DQE Energy Services' development, operation and
maintenance of energy facilities and, for a single customer, alternative fuel
facilities (Energy Services business segment), (5) DQE Financial's collection
and processing of landfill gas and management of structured finance and
alternative energy investments (Financial business segment) and (6) DQE
Enterprises' management of electronic commerce and energy technologies
investment portfolios (Enterprises business segment).
We also report an "all other" category, to include our other subsidiaries
below the quantitative threshold for disclosure, and corporate administrative
functions, financing, and insurance services for our various affiliates.
Operating revenues in our "all other" category are comprised of revenues from
our propane delivery and telecommunications business lines, and from our bottled
water business in 2001.
Because AquaSource is reported as a discontinued operation, we no longer
report a water distribution business segment. (See Note I.)
14
Business Segments for the Three Months Ended:
- -----------------------------------------------------------------------------------------------------
(Millions of Dollars)
--------------------------------------------------------
Electricity Electricity Energy
Delivery Supply CTC Services Financial
--------------------------------------------------------
September 30, 2002
- -----------------------------------------------------------------------------------------------------
Operating revenues $ 99.4 $139.9 $15.3 $14.8 $ 3.7
Operating expenses 37.9 130.3 0.6 7.0 10.1
Depreciation and amortization expense 14.1 -- 14.0 0.5 1.8
- -----------------------------------------------------------------------------------------------------
Operating income (loss) 47.4 9.6 0.7 7.3 (8.2)
Other income 6.0 -- -- 1.4 13.3
Interest and other charges 16.9 -- -- 0.2 0.5
- -----------------------------------------------------------------------------------------------------
Income (loss) before taxes 36.5 9.6 0.7 8.5 4.6
Income taxes 15.2 3.9 0.3 2.9 (0.8)
- -----------------------------------------------------------------------------------------------------
Income (loss) from continuing operations 21.3 5.7 0.4 5.6 5.4
Dividends on preferred stock -- -- -- -- --
- -----------------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations
available for common stock $ 21.3 $ 5.7 $ 0.4 $ 5.6 $ 5.4
=====================================================================================================
Assets $1,891.8 $ -- $31.8 $38.7 $610.9
=====================================================================================================
Capital expenditures $ 16.4 $ -- $ -- $ 0.1 $ 0.2
=====================================================================================================
- -----------------------------------------------------------------------------------------------
(Millions of Dollars)
- -----------------------------------------------------------------------------------------------
Enterprises Other Eliminations Consolidated
--------------------------------------------------
September 30, 2002
- -----------------------------------------------------------------------------------------------
Operating revenues $ -- $ 8.3 $(0.5) $ 280.9
Operating expenses 0.2 13.8 (0.1) 199.8
Depreciation and amortization expense -- 1.1 -- 31.5
- -----------------------------------------------------------------------------------------------
Operating income (loss) (0.2) (6.6) (0.4) 49.6
Other income 0.2 0.3 (4.8) 16.4
Interest and other charges -- 6.5 (4.5) 19.6
- -----------------------------------------------------------------------------------------------
Income (loss) before taxes -- (12.8) (0.7) 46.4
Income taxes -- (4.3) -- 17.2
- -----------------------------------------------------------------------------------------------
Income (loss) from continuing operations -- (8.5) (0.7) 29.2
Dividends on preferred stock -- 0.2 -- 0.2
- -----------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations
available for common stock $ -- $ (8.7) $(0.7) $ 29.0
===============================================================================================
Assets $12.6 $121.3 $ -- $2,707.1
===============================================================================================
Capital expenditures $ -- $ 3.5 $ -- $ 20.2
===============================================================================================
15
Business Segments for the Three Months Ended:
- ------------------------------------------------------------------------------------------------------
(Millions of Dollars)
---------------------------------------------------------
Electricity Electricity Energy
Delivery Supply CTC Services Financial
---------------------------------------------------------
September 30, 2001
- ------------------------------------------------------------------------------------------------------
Operating revenues $ 84.5 $125.9 $ 85.8 $10.2 $ 3.7
Operating expenses 36.1 125.9 3.8 8.5 10.2
Depreciation and amortization expense 15.0 -- 77.8 0.5 1.0
- ------------------------------------------------------------------------------------------------------
Operating income (loss) 33.4 -- 4.2 1.2 (7.5)
Other income 8.8 -- -- 2.7 15.5
Interest and other charges 19.3 -- -- 0.1 1.1
- ------------------------------------------------------------------------------------------------------
Income (loss) before taxes 22.9 -- 4.2 3.8 6.9
Income taxes 8.9 -- 1.5 1.3 (1.8)
- ------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations 14.0 -- 2.7 2.5 8.7
Dividends on preferred stock -- -- -- -- --
- ------------------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations
available for common stock $ 14.0 $ -- $ 2.7 $ 2.5 $ 8.7
======================================================================================================
Assets (1) $1,702.5 $ -- $134.3 $35.2 $623.6
======================================================================================================
Capital expenditures $ 15.4 $ -- $ -- $ 0.2 $ 14.9
======================================================================================================
- -----------------------------------------------------------------------------------------------
(Millions of Dollars)
--------------------------------------------------
Enterprises Other Eliminations Consolidated
--------------------------------------------------
September 30, 2001
- -----------------------------------------------------------------------------------------------
Operating revenues $ 2.3 $ 11.2 $(1.8) $ 321.8
Operating expenses 1.8 13.9 (2.6) 197.6
Depreciation and amortization expense 0.4 1.8 -- 96.5
- -----------------------------------------------------------------------------------------------
Operating income (loss) 0.1 (4.5) 0.8 27.7
Other income 14.7 1.0 (8.9) 33.8
Interest and other charges -- 11.6 (7.5) 24.6
- -----------------------------------------------------------------------------------------------
Income (loss) before taxes 14.8 (15.1) (0.6) 36.9
Income taxes 6.0 (3.4) -- 12.5
- -----------------------------------------------------------------------------------------------
Income (loss) from continuing operations 8.8 (11.7) (0.6) 24.4
Dividends on preferred stock -- 0.2 -- 0.2
- -----------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations
available for common stock $ 8.8 $(11.9) $(0.6) $ 24.2
===============================================================================================
Assets (1) $35.2 $314.9 $ -- $2,845.7
===============================================================================================
Capital expenditures $ 0.1 $ 2.5 $ -- $ 33.1
===============================================================================================
(1) Relates to assets as of December 31, 2001.
16
Business Segments for the Nine Months Ended:
- ------------------------------------------------------------------------------------------------------
(Millions of Dollars)
---------------------------------------------------------
Electricity Electricity Energy
Delivery Supply CTC Services Financial
---------------------------------------------------------
September 30, 2002
- ------------------------------------------------------------------------------------------------------
Operating revenues $265.1 $358.0 $113.9 $36.9 $ 11.6
Operating expenses 114.0 342.7 5.0 18.6 32.5
Depreciation and amortization expense 42.3 -- 105.0 1.5 5.3
- ------------------------------------------------------------------------------------------------------
Operating income (loss) 108.8 15.3 3.9 16.8 (26.2)
Other income 26.3 -- -- 2.7 42.0
Interest and other charges 55.8 -- -- 0.5 1.2
- ------------------------------------------------------------------------------------------------------
Income (loss) before taxes 79.3 15.3 3.9 19.0 14.6
Income taxes 32.3 6.2 1.4 6.5 (1.7)
- ------------------------------------------------------------------------------------------------------
Income (loss) before impairment 47.0 9.1 2.5 12.5 16.3
Impairment, net -- -- -- -- --
- ------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations 47.0 9.1 2.5 12.5 16.3
Dividends on preferred stock -- -- -- -- --
- ------------------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations
available for common stock $ 47.0 $ 9.1 $ 2.5 $12.5 $ 16.3
======================================================================================================
Capital expenditures $ 51.3 $ -- $ -- $ 0.4 $ 1.7
======================================================================================================
- -----------------------------------------------------------------------------------------------
(Millions of Dollars)
--------------------------------------------------
Enterprises Other Eliminations Consolidated
--------------------------------------------------
September 30, 2002
- -----------------------------------------------------------------------------------------------
Operating revenues $ 0.9 $ 33.4 $(1.5) $818.3
Operating expenses 1.9 46.8 (0.4) 561.1
Depreciation and amortization expense 0.1 3.7 -- 157.9
- -----------------------------------------------------------------------------------------------
Operating income (loss) (1.1) (17.1) (1.1) 99.3
Other income 0.6 2.5 (18.2) 55.9
Interest and other charges -- 23.2 (16.8) 63.9
- -----------------------------------------------------------------------------------------------
Income (loss) before taxes (0.5) (37.8) (2.5) 91.3
Income taxes (0.3) (13.0) -- 31.4
- -----------------------------------------------------------------------------------------------
Income (loss) before impairment (0.2) (24.8) (2.5) 59.9
Impairment, net (10.8) -- -- (10.8)
- -----------------------------------------------------------------------------------------------
Income (loss) from continuing operations (11.0) (24.8) (2.5) 49.1
Dividends on preferred stock -- 0.5 -- 0.5
- -----------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations
available for common stock $(11.0) $(25.3) $(2.5) $ 48.6
===============================================================================================
Capital expenditures $ -- $ 7.0 $ -- $ 60.4
===============================================================================================
17
Business Segments for the Nine Months Ended:
- ------------------------------------------------------------------------------------------------------
(Millions of Dollars)
---------------------------------------------------------
Electricity Electricity Energy
Delivery Supply CTC Services Financial
---------------------------------------------------------
September 30, 2001
- ------------------------------------------------------------------------------------------------------
Operating revenues $238.9 $332.3 $233.8 $19.2 $ 18.6
Operating expenses 115.3 332.3 10.4 16.1 30.8
Depreciation and amortization expense 44.6 -- 207.3 1.4 3.1
- ------------------------------------------------------------------------------------------------------
Operating income (loss) 79.0 -- 16.1 1.7 (15.3)
Other income 30.5 -- -- 8.6 50.0
Interest and other charges 59.7 -- -- 0.4 5.3
- ------------------------------------------------------------------------------------------------------
Income (loss) before taxes 49.8 -- 16.1 9.9 29.4
Income taxes 19.9 -- 5.7 3.3 (0.6)
- ------------------------------------------------------------------------------------------------------
Income (loss) before impairment 29.9 -- 10.4 6.6 30.0
Impairment, net -- -- -- -- --
- ------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations 29.9 -- 10.4 6.6 30.0
Dividends on preferred stock -- -- -- -- --
- ------------------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations
available for common stock $ 29.9 $ -- $ 10.4 $ 6.6 $ 30.0
======================================================================================================
Capital expenditures $ 41.9 $ -- $ -- $ 1.1 $ 35.2
======================================================================================================
- -----------------------------------------------------------------------------------------------
(Millions of Dollars)
--------------------------------------------------
Enterprises Other Eliminations Consolidated
--------------------------------------------------
September 30, 2001
- -----------------------------------------------------------------------------------------------
Operating revenues $ 13.2 $ 55.7 $ (7.9) $903.8
Operating expenses 11.2 55.0 (11.6) 559.5
Depreciation and amortization expense 2.0 5.7 -- 264.1
- -----------------------------------------------------------------------------------------------
Operating income (loss) -- (5.0) 3.7 80.2
Other income 17.5 (15.3) (28.2) 63.1
Interest and other charges 0.1 37.3 (22.8) 80.0
- -----------------------------------------------------------------------------------------------
Income (loss) before taxes 17.4 (57.6) (1.7) 63.3
Income taxes 6.2 (14.8) -- 19.7
- -----------------------------------------------------------------------------------------------
Income (loss) before impairment 11.2 (42.8) (1.7) 43.6
Impairment, net (27.7) -- -- (27.7)
- -----------------------------------------------------------------------------------------------
Income (loss) from continuing operations (16.5) (42.8) (1.7) 15.9
Dividends on preferred stock -- 0.4 -- 0.4
- -----------------------------------------------------------------------------------------------
Earnings (loss) from continuing operations
available for common stock $(16.5) $(43.2) $ (1.7) $ 15.5
===============================================================================================
Capital expenditures $ 0.1 $ 6.9 $ -- $ 85.2
===============================================================================================
18
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Part I, Item 2 of this Quarterly Report on Form 10-Q should be read in
conjunction with our Annual Report on Form 10-K for the year ended December 31,
2001 filed with the Securities and Exchange Commission (SEC), and the condensed
consolidated financial statements, which are set forth in Part I, Item 1 of this
Report.
DQE, Inc. delivers essential products and related services, including
electricity, water and communications, to more than one million customers
throughout the United States. Our subsidiaries include Duquesne Light Company;
AquaSource, Inc.; DQE Energy Services, LLC; Duquesne Power, Inc.; DQE Financial
Corp.; DQE Enterprises, Inc.; DQE Communications, Inc.; ProAm, Inc.; Cherrington
Insurance, Ltd.; and DQE Capital Corporation.
Duquesne Light, our largest operating subsidiary, is an electric utility
engaged in the transmission and distribution of electric energy.
AquaSource is a water resource management company. Since July 2002, we
entered agreements to sell more than 85% of AquaSource's assets. AquaSource is
now reported as a discontinued operation. (See Note I.)
DQE Energy Services is an energy facilities management company that
provides energy outsourcing solutions including development, operation and
maintenance of energy and alternative fuel facilities.
Duquesne Power Inc. was formed in April 2002 to explore various alternative
generation supply options.
DQE Financial owns and operates landfill gas collection and processing
systems, and is an investment and portfolio management organization focused on
structured finance and alternative energy investments.
DQE Enterprises manages our remaining electronic commerce and energy
technologies investment portfolios.
Our other business lines include the following: propane distribution,
communications systems, and financing and insurance services for DQE and various
affiliates.
Service Areas
Duquesne Light's electric utility operations provide service to
approximately 586,000 direct customers in southwestern Pennsylvania (including
in the City of Pittsburgh), a territory of approximately 800 square miles.
ProAm, our propane delivery business, provides service to over 70,000
customers in seven states. Our other business lines have operations and
investments in several states and Canada.
Regulation
DQE and Duquesne Light are subject to the accounting and reporting
requirements of the SEC. Duquesne Light's electric delivery business is also
subject to regulation by the Pennsylvania Public Utility Commission (PUC) and
the Federal Energy Regulatory Commission (FERC) with respect to rates for
delivery of electric power, accounting and other matters.
Business Segments
This information is set forth in "Results of Operations" below and in
"Business Segments and Related Information," Note J to our condensed
consolidated financial statements.
Forward-looking Statements
We use forward-looking statements in this report. Statements that are not
historical facts are forward-looking statements, and are based on beliefs and
assumptions of our management, and on information currently available to
management. Forward-looking statements include statements preceded by, followed
by or using such words as "believe," "expect," "anticipate," "plan," "estimate"
or similar expressions. Such statements speak only as of the date they are made,
and we undertake no obligation to update publicly any of them in light of new
information or future events. Actual results may materially differ from those
implied by forward-looking statements due to known and unknown risks and
uncertainties, some of which are discussed in "Outlook" below.
Recent Accounting Pronouncements
In June 2001 the Financial Accounting Standards Board (FASB) issued a new
accounting standard, Statement of Financial Accounting Standards (SFAS) No. 143,
"Accounting for Asset Retirement Obligations."
SFAS No. 143 addresses financial accounting and reporting for obligations
associated with the retirement of tangible long-lived assets and the associated
asset retirement costs. Specifically, this standard requires entities to record
the fair value of a liability for an asset retirement obligation in the period
in which it is incurred, if a reasonable estimate of fair value can be made. The
entity is required to capitalize the cost by increasing the carrying amount of
the related long-lived asset. The capitalized cost is then depreciated over the
useful life of the related asset. Upon settlement of the liability, an entity
either
19
settles the obligation for its recorded amount or incurs a gain or loss. The
standard is effective for fiscal years beginning after June 15, 2002. We are
currently evaluating, but have yet to determine, the impact that the adoption of
SFAS No. 143 will have on our financial statements.
RESULTS OF OPERATIONS
Overall Performance
Three months ended September 30, 2002. Earnings from continuing operations
available for common stock were $29.0 million or $0.39 per share in the third
quarter of 2002, compared to earnings of $24.2 million or $0.43 per share in the
third quarter of 2001, an aggregate increase of $4.8 million. The average shares
outstanding increased 18.2 million, or 32.6%, principally due to the June 2002
common stock offering.
The increase in earnings from continuing operations is due to a number of
factors:
. Pittsburgh experienced hotter than normal weather in the third quarter
of 2002, due to the third warmest summer on record in our nation's
history, which resulted in higher demand for cooling.
. During 2002, Duquesne Light began operating under its new provider of
last resort arrangement (POLR II, described below).
. Third quarter earnings increased at the Energy Services business
segment.
. Savings from our fourth quarter of 2001 corporate restructuring, and
our continued focus on other cost reductions, contributed to third
quarter of 2002 income.
. Interest expense in the third quarter of 2002 was reduced due to debt
retirements in late 2001 and 2002 and favorable interest rates on our
variable rate, tax-exempt debt.
The following factors partially offset these contributions to earnings from
continuing operations:
. Although the $8.4 million after-tax gain in the third quarter of 2001
resulting from the sale of the Pittsburgh International Airport energy
facility contributed to 2001 income, we recognized no such gain in the
third quarter of 2002.
. Income from the CTC business segment declined following the full
collection of the CTC balance for most of our customers.
After considering discontinued operations, the earnings available for
common stock were $26.8 million or $0.36 per share in the third quarter of 2002,
compared to earnings of $22.5 million or $0.40 per share in the third quarter of
2001, an aggregate increase of $4.3 million.
Nine months ended September 30, 2002. Earnings from continuing operations
available for common stock were $48.6 million or $0.78 per share in the first
nine months of 2002, compared to earnings of $15.5 million or $0.28 per share in
the first nine months of 2001, an increase of $33.1 million. The average shares
outstanding increased 6.7 million, or 12.0%, principally due to the June 2002
common stock offering.
The factors described above as affecting earnings from continuing
operations in the third quarter of 2002 also impacted the results of the first
nine months of 2002. The following are additional factors that impacted the
results of the first nine months of 2002:
. After-tax investment impairment charges of $10.8 million in 2002 and
$27.7 million in 2001 related to the investments held by the
Enterprises business segment. (See Note D.)
. An additional $4.9 million after-tax loss recorded in 2001 on the sale
of our bottled water business.
. Decreased earnings in 2002 from our Financial business segment due to
the sale of a significant portion of our affordable housing portfolio
in the first quarter of 2002, coupled with decreased landfill gas
production and lower gas sales prices in 2002 as compared to 2001.
After-tax impairment charges relating to discontinued operations totaling
$100.9 million were recorded in the second quarter of 2002, while after-tax
impairment charges of $99.7 million were recorded in the second quarter of 2001.
(See Notes D and I.)
A charge of $113.7 million was recorded effective as of January 1, 2002
related to the cumulative effect of a change in accounting principle relating to
the impairment of goodwill resulting from the adoption of SFAS No. 142. (See
Note D.)
After considering discontinued operations and the cumulative effect charge,
the loss attributable to common stock was $167.5 million or $2.68 per share for
the first nine months of 2002, compared to a loss of $87.2 million or $1.56 per
share in the first nine months of 2001.
20
Results of Operations by Business Segment
We report the results of our business segments, determined by products,
services and regulatory environment as follows: (1) Duquesne Light's
transmission and distribution of electricity (electricity delivery business
segment), (2) Duquesne Light's supply of electricity (electricity supply
business segment), (3) Duquesne Light's collection of transition costs (CTC
business segment), (4) DQE Energy Services' development, operation and
maintenance of energy facilities and, for a single customer, alternative fuel
facilities (Energy Services business segment), (5) DQE Financial's collection
and processing of landfill gas and the management of structured finance and
alternative energy investments (Financial business segment), and (6) DQE
Enterprises' management of electronic commerce and energy technologies
investment portfolios (Enterprises business segment).
We also report an "all other" category to include our other subsidiaries
below the quantitative threshold for disclosure, and corporate administrative
functions, financing, and insurance services for our various affiliates.
Because AquaSource is now reported as a discontinued operation, we no
longer report a water distribution business segment. (See Note I.)
We have restated prior periods where appropriate to present segment
information consistent with the manner that is currently utilized by management.
Note J shows the financial results of each principal business segment in tabular
form. Following is a discussion of these results.
Electricity Delivery Business Segment.
Three months ended September 30, 2002. The electricity delivery business
segment reported $21.3 million of income in the third quarter of 2002 compared
to $14.0 million in the third quarter of 2001, an increase of $7.3 million, or
52.1%, as a result of higher revenues in 2002 due to the hotter than normal
summer temperatures.
Operating revenues for this business segment are primarily derived from the
delivery of electricity, including related excise taxes. Sales to residential
and commercial customers are primarily influenced by weather conditions. Warmer
summer and colder winter seasons lead to increased customer use of electricity
for cooling and heating. Commercial sales also are affected by regional
development. Sales to industrial customers are influenced by national and global
economic conditions.
Operating revenues increased by $14.9 million or 17.6% compared to the
third quarter of 2001. The increase can be primarily attributed to the 11.3%
increase in kilowatt-hour sales to customers from 2001. In addition, there has
been a $6.2 million increase in 2002 in the excise taxes that are collected
through revenue. The largest excise tax increase is in the Pennsylvania revenue
neutral reconciliation (RNR) tax rate, which became effective January 1, 2002.
Electric distribution companies, such as Duquesne Light, are permitted to
recover this cost from consumers on a current basis. (See "Legal Proceedings.")
The hotter than normal summer temperatures in the Pittsburgh region
resulted in residential and commercial sales increasing 20.3% and 10.0%,
respectively, compared to 2001, in response to higher cooling demands.
Industrial sales, which are less sensitive to the weather, also increased by
3.0% due to higher sales to industrial customers in the primary metals sector.
The following table sets forth kilowatt-hours (KWH) delivered to electric
utility customers.
- ---------------------------------------------------------------
KWH Delivered
----------------------
(In Millions)
----------------------
Third Quarter 2002 2001 Change
- ---------------------------------------------------------------
Residential 1,235 1,027 20.3%
Commercial 1,863 1,693 10.0%
Industrial 871 846 3.0%
- ------------------------------------------------------
Sales to Electric Utility Customers 3,969 3,566 11.3%
===============================================================
Operating expenses for the electricity delivery business segment consist
primarily of costs to operate and maintain the transmission and distribution
system; meter reading, billing and collection costs; customer service;
administrative expenses; and non-income taxes, such as gross receipts, property
and payroll taxes. Operating expenses increased by $1.8 million or 5.0% compared
to the third quarter of 2001, primarily due to the increase in gross receipts
tax of approximately $4.0 million from the increased RNR in 2002. This increase
was partially offset by the corporate restructuring that occurred in the fourth
quarter of 2001, as well as our cost reduction initiatives, which continue to
generate incremental cost savings.
Other income decreased $2.8 million or 31.8% compared to the third quarter
of 2001, primarily due to higher interest earnings in the third quarter of 2001.
Interest and other charges include interest on long-term debt, other
interest and preferred stock dividends of Duquesne Light. Interest and other
charges decreased $2.4 million or 12.4% compared to the third quarter of 2001
due to debt retirements during August 2002 totaling $110.0 million, which
21
reduced interest expense by $1.3 million, coupled with favorable interest rates
on the variable rate, tax-exempt debt.
Nine months ended September 30, 2002. The electricity delivery business
segment reported $47.0 million of income in the first nine months of 2002,
compared to $29.9 million in the first nine months of 2001, an increase of $17.1
million, or 57.2%. This improvement is a result of higher operating revenues due
to the hotter than normal summer weather coupled with lower operating expenses
due to the corporate restructuring that occurred in the fourth quarter of 2001,
as well as our cost reduction initiatives, which continue to generate
incremental cost savings.
Operating revenues increased by $26.2 million or 11.0% compared to the
first nine months of 2001. The increase can be largely attributed to the $16.2
million increase in the excise taxes that are collected through revenue, in
particular the RNR increase. In addition, sales to electric utility customers
increased approximately 5.1% due to the hotter than normal summer weather.
In addition to the nation's third warmest summer, we also experienced the
fifth warmest winter on record. The higher than normal summer demand for cooling
more than offset the lower than normal winter demand for heating, and
residential and commercial sales increased by 9.0% and 5.0%, respectively.
Industrial sales, which are less sensitive to the weather, also increased by
1.2% due to higher sales to industrial customers in the primary metals sector.
The following table sets forth KWH delivered to electric utility customers.
- ----------------------------------------------------------------
KWH Delivered
-----------------------
(In Millions)
-----------------------
First Nine Months 2002 2001 Change
- ----------------------------------------------------------------
Residential 2,993 2,746 9.0%
Commercial 4,982 4,747 5.0%
Industrial 2,534 2,504 1.2%
- -------------------------------------------------------
Sales to Electric Utility Customers 10,509 9,997 5.1%
================================================================
Operating expenses decreased by $1.3 million or 1.1% compared to the first
nine months of 2001. This decrease is due to the corporate restructuring that
occurred in the fourth quarter of 2001, as well as our cost reduction
initiatives, which continue to generate incremental cost savings. Offsetting
these decreases is an increase in gross receipts tax of approximately $11.5
million due to the increased RNR in 2002.
Other income decreased $4.2 million or 13.8% compared to the first nine
months of 2001. During the first nine months of 2002, we experienced lower
interest earnings compared to the first nine months of 2001.
Interest and other charges decreased $3.9 million or 6.5% compared to the
first nine months of 2001 due to debt retirements during August 2002 totaling
$110.0 million, which reduced interest expense by $1.3 million, coupled with
favorable interest rates on the variable rate, tax-exempt debt.
Electricity Supply Business Segment.
Three months ended September 30, 2002. The electricity supply business
segment reported income of $5.7 million in the third quarter of 2002, compared
with income of zero in the third quarter of 2001. For the period April 28, 2000
through December 31, 2001, this segment's financial results reflected our
initial provider of last resort service arrangement (POLR I), which was designed
to be income neutral to Duquesne Light. During the first quarter of 2002,
Duquesne Light began operating under POLR II, which extends the provider of last
resort service (and the PUC-approved rates for the supply of electricity) beyond
the final CTC collection through December 31, 2004. POLR II also permits
Duquesne Light, following CTC collection for each rate class, an average margin
of 0.5 cents per KWH supplied.
Operating revenues for this business segment are derived primarily from the
supply of electricity for delivery to retail customers and, to a much lesser
extent, the supply of electricity to wholesale customers. Retail energy
requirements fluctuate as the number of customers participating in customer
choice changes. Energy requirements for residential and commercial customers are
also influenced by weather conditions; temperature extremes lead to increased
customer use of electricity for cooling and heating. Commercial energy
requirements are also affected by regional development. Energy requirements for
industrial customers are primarily influenced by national and global economic
conditions.
Short-term sales to other utilities are made at market rates. Fluctuations
result primarily from excess daily energy deliveries to Duquesne Light's
electricity delivery system.
Operating revenues increased $14.0 million or 11.1% compared to the third
quarter of 2001, due to higher average generation rates. The average generation
rate increased January 1, 2002, due to scheduled rate increases. In addition,
the average rates increase incrementally as rate classes become subject to the
POLR II arrangement. Those higher
22
average generation rates more than offset the 1.4% decline in total KWH
supplied.
The following table sets forth KWH supplied for customers who had not
chosen an alternative generation supplier, segregated by those customers
supplied under the POLR I or the POLR II contract.
- ------------------------------------------------------------
KWH Supplied
---------------------------------
(In Millions)
---------------------------------
Third Quarter 2002 2001
- ------------------------------------------------------------
POLR I POLR II Total POLR I
- ------------------------------------------------------------
Residential 60 783 843 675
Commercial 311 1,085 1,396 1,627
Industrial 530 277 807 806
- ------------------------------------------------------------
KWH Sales 901 2,145 3,046 3,108
Sales to Other Utilities 53 36
- ------------------------------------------------------------
Total Sales 3,099 3,144
============================================================
Operating expenses for the electricity supply business segment consist of
costs to obtain energy for our provider of last resort service and gross
receipts tax, both of which fluctuate in direct relation to operating revenues.
Operating expenses increased $4.4 million or 3.5% compared to the third quarter
of 2001. As a result of the higher average generation rates charged to customers
in the third quarter of 2002, the cost of energy increased due to the
pass-through nature of the provider of last resort arrangements.
Nine months ended September 30, 2002. The electricity supply business
segment reported income of $9.1 million in the first nine months of 2002,
compared to income of zero in the first nine months of 2001. During the first
quarter of 2002, Duquesne Light began operating under the POLR II arrangement,
discussed above.
Operating revenues increased $25.7 million or 7.7% compared to the first
nine months of 2001, due to higher average generation rates, discussed above.
These higher average generation rates more than offset the 2.8% decline in total
KWH supplied.
The following table sets forth KWH supplied for customers who had not
chosen an alternative generation supplier, segregated by those customers
supplied under the POLR I or the POLR II arrangement.
- ------------------------------------------------------------
KWH Supplied
---------------------------------
(In Millions)
---------------------------------
First Nine Months 2002 2001
- ------------------------------------------------------------
POLR I POLR II Total POLR I
- ------------------------------------------------------------
Residential 610 1,465 2,075 1,818
Commercial 2,257 1,473 3,730 4,103
Industrial 2,005 332 2,337 2,342
- ------------------------------------------------------------
KWH Sales 4,872 3,270 8,142 8,263
Sales to Other Utilities 164 285
- ------------------------------------------------------------
Total Sales 8,306 8,548
============================================================
Operating expenses increased $10.4 million or 3.1% compared to the first
nine months of 2001. As a result of the higher average generation rates charged
to customers in the first nine months of 2002, the cost of energy increased due
to the pass-through nature of the provider of last resort arrangements.
CTC Business Segment.
Three months ended September 30, 2002. For the CTC business segment,
operating revenues are derived by billing electric delivery customers for
generation-related transition costs. Duquesne Light is allowed to earn an 11%
pre-tax return on the net of tax CTC balance. As revenues are billed to
customers on a monthly basis, we amortize the CTC balance. The resulting
decrease in the CTC balance causes a decline in the return earned by Duquesne
Light.
In the third quarter of 2002, the CTC business segment reported income of
$0.4 million compared to $2.7 million during the same period in 2001, a decrease
of $2.3 million or 85.2%.
Operating revenues decreased $ 70.5 million or 82.2%, due to the full
collection of the allocated CTC balance as of September 30, 2002 for most of our
customers, as well as scheduled decreases in the average CTC rate charged to
customers from 2001 to 2002. As of September 30, 2002, the CTC balance has been
fully collected for approximately 95% of Duquesne Light's customers, and
approximately 87% of the KWH sales for the first nine months of 2002.
Operating expenses consist solely of gross receipts tax, which fluctuates
in direct relation to operating revenues. Operating expenses decreased $3.2
million or 84.2% compared to the third quarter of 2001.
23
Depreciation and amortization expense consists of the amortization of
transition costs. There was a decrease of $63.8 million or 82.0% compared to the
third quarter of 2001, primarily due to the full collection of the allocated CTC
balance for certain customers, as discussed above.
Nine months ended September 30, 2002. In the first nine months of 2002, the
CTC business segment reported income of $2.5 million compared to $10.4 million
during the same period in 2001, a decrease of $7.9 million or 76.0%. As the CTC
balance is collected from customers, this results in a decline in the return
earned by Duquesne Light.
Operating revenues decreased $119.9 million or 51.3% compared to the first
nine months of 2001. This decrease is due to the full collection of the
allocated CTC balance for most of our customers, as well as scheduled decreases
in the average CTC rate as discussed above.
Operating expenses decreased $5.4 million or 51.9% compared to the first
nine months of 2001, due to the decrease in operating revenues.
Depreciation and amortization expense decreased $102.3 million or 49.3%
compared to the first nine months of 2001, primarily due to the full collection
of the allocated CTC balance for certain customers, as discussed above.
Energy Services Business Segment
Three months ended September 30, 2002. The Energy Services business segment
reported income of $5.6 million in the third quarter of 2002, compared to $2.5
million in the third quarter of 2001, an increase of $3.1 million or 124.0%.
This increase resulted primarily from an entire quarter's income from
alternative fuel service contracts which were entered into during 2001 and the
commercial opening of the Detroit Metro Airport energy facility in the second
quarter of 2002.
Operating revenues are primarily derived from the facility management
services for industrial, airport and alternative fuel customers. Operating
revenues increased $4.6 million or 45.1% compared to the third quarter of 2001.
This increase is due to an entire quarter's revenue from the new alternative
fuel service contracts and the airport energy facility.
Operating expenses consist of the operating and maintenance costs to manage
the facilities, as well as general corporate overhead. Operating expenses
decreased $1.5 million or 17.6% compared to the third quarter of 2001, primarily
due to decreased overhead, including employee compensation costs.
Other income consists of income from tax credits generated from alternative
fuel facilities and gains recognized on the sale of assets. Other income
decreased $1.3 million or 48.1% compared to the third quarter of 2001, due to
the recognition of an early completion bonus and construction management fee
income on a new alternative fuel facility in the third quarter of 2001.
Nine months ended September 30, 2002. The Energy Services business segment
reported income of $12.5 million for the first nine months of 2002, compared to
income of $6.6 million in 2001, an increase of $5.9 million or 89.4%. This
increase resulted primarily from increased facility management income for the
entire period from the alternative fuel service contracts entered into during
2001 and the airport energy facility.
Operating revenues increased $17.7 million or 92.2% compared to the first
nine months of 2001. This increase is due to the increased facility management
income from the additional alternative fuel service contracts and the airport
energy facility.
Operating expenses increased $2.5 million or 15.5% compared to the first
nine months of 2001. This increase resulted from the additional alternative fuel
facility management service contracts and the airport energy facility.
Other income decreased $5.9 million or 68.6% compared to the first nine
months of 2001, due to gains recognized on sales of alternative fuel property
and recognition of an early completion bonus and construction management fee
income on a new alternative fuel facility in 2001.
Financial Business Segment.
Three months ended September 30, 2002. In the third quarter of 2002, the
Financial business segment reported income of $5.4 million, compared to income
of $8.7 million in the third quarter of 2001, a decrease of $3.3 million or
37.9%. This decrease resulted primarily from lower landfill gas production and
less income due to the first quarter 2002 sale of most of the affordable housing
portfolio.
Depreciation and amortization expense consists of the depreciation of
landfill gas equipment and gas rights. There was an increase of $0.8 million or
80.0% compared to the third quarter of 2001. This increase resulted from
additional depreciation on portions of the Fresh Kills landfill gas investments.
24
Other income consists of income from leveraged lease and affordable housing
investments, tax credits generated from landfill, natural gas, and alternative
fuel investments, and gains recognized on the sales of investments. Other income
decreased $2.2 million or 14.2% compared to the third quarter of 2001, due to
reduced tax credits as a result of the sale of most of the affordable housing
portfolio, and lower landfill gas production.
Nine months ended September 30, 2002. The Financial business segment
reported income of $16.3 million, compared to income of $30.0 million in 2001, a
decrease of $13.7 million or 45.7%. The decrease resulted primarily from lower
landfill gas production, lower gas sales prices, and less income due to the sale
of most of the affordable housing portfolio.
Operating revenues in this business segment are primarily derived from the
sale of landfill gas. Operating revenues decreased $7.0 million or 37.6%
compared to the first nine months of 2001. This decrease is due to lower
landfill gas production and lower landfill gas sales prices.
Depreciation and amortization expense increased $2.2 million or 71.0%
compared to the first nine months of 2001. This increase resulted from
additional depreciation on portions of the Fresh Kills landfill gas investments.
Other income decreased $8.0 million or 16.0% as compared to 2001, due to
reduced tax credits as a result of the sale of most of the affordable housing
portfolio, and lower landfill gas production.
Interest and other charges decreased $4.1 million or 77.4% as compared to
the first nine months of 2001, due to the retirement of $85.0 million of medium
term notes in 2001.
Enterprises Business Segment.
Three months ended September 30, 2002. The Enterprises business segment
reported zero income in the third quarter of 2002, compared to $8.8 million
income in the third quarter of 2001. Included in the third quarter of 2001 was
an $8.4 million after-tax gain from the sale of the Pittsburgh International
Airport energy facility. We have been in the process of divesting the remaining
investments of this business segment, and will continue to do so as
opportunities arise and market conditions permit.
Nine months ended September 30, 2002. The Enterprises business segment
reported an $11.0 million loss for the nine months ended September 30, 2002,
compared to a $16.5 million loss for the same period during 2001. Included in
the 2002 loss is a $10.8 million after-tax charge for the impairment of five
investments. A $27.7 million after-tax charge for the sale of two investments
and impairment of seven other investments was included in the second quarter of
2001 results. (See Note D.)
All Other.
Three months ended September 30, 2002. The all other category reported a
loss of $8.7 million in the third quarter of 2002 compared to an $11.9 million
loss in the third quarter of 2001, an improvement of $3.2 million or 26.9%. The
improvement resulted mainly from lower interest expense, partially offset by
lower propane and telecommunications revenues.
In the third quarter of 2002, operating revenues decreased by $2.9 million,
or 25.9% compared to the third quarter of 2001. This decrease was the result of
decreased revenues of $1.1 million due to lower propane prices and propane
sales, and $1.8 million due to lower telecommunications lease revenue resulting
from the loss of two customers who previously filed for bankruptcy protection.
Interest and other charges include interest on long-term debt, other
interest, and preferred stock. A decrease of $5.1 million, or 44.0% in the third
quarter of 2002 as compared to the third quarter of 2001 was primarily due to
lower short-term borrowing levels, lower interest rates and the retirement of
$150 million of floating rate notes in January 2002.
Nine months ended September 30, 2002. The all other category reported a
loss of $25.3 million for the first nine months of 2002, compared to a loss of
$43.2 million for the first nine months of 2001. The improvement of $17.9
million was primarily due to lower interest expense in 2002 and the loss on the
sale of the bottled water business recognized in 2001.
Operating revenues decreased $22.3 million, or 40.0% compared to the first
nine months of 2001, primarily due to decreased revenues of $8.1 million from
the sale of our bottled water business and $9.8 million due to lower propane
prices and propane sales.
For the first nine months of 2002, operating expenses decreased $8.2
million, or 14.9% as compared to the same period in 2001. This decrease was
primarily due to an $8.4 million decrease in expenses following the sale of the
bottled water business, and a decrease in expenses from the cost savings
associated with the 2001 restructuring, offset by the $1.9 million increase in
expenses associated with the write-off of the costs associated with the
previously proposed generating station. (See "Rate Matters - Provider of Last
Resort.")
25
For the nine months ended September 30, 2002, other income increased $17.8
million, or 116.3% compared to the first nine months of 2001. This increase is
primarily due to the loss on the 2001 sale of the bottled water business.
Interest expense decreased $14.1 million, or 37.8% in the first nine months
of 2002 compared to the same period in 2001. This decrease was primarily due to
lower short-term borrowing levels and the retirement of $150.0 million of
floating rate notes in January 2002.
Discontinued Operations.
Three months ended September 30, 2002. The loss from discontinued
operations for the third quarter of 2002 was $2.2 million. This loss was
comprised of income from operations of $4.0 million and a loss on disposal of
$6.2 million due to costs associated with the sale. The $1.7 million loss in the
third quarter of 2001 resulted from operations. (See Note I.)
Nine months ended September 30, 2002. The loss from discontinued operations
for the first nine months of 2002 was $102.4 million, which was comprised of
$4.7 million of income from operations and the loss on disposal of $107.1
million. The $102.4 million loss resulted primarily from the $100.9 million
after-tax charge related to the impairment of long-lived assets taken in the
second quarter of 2002. For the first nine months of 2001, the loss from
discontinued operations was $102.7 million. This resulted primarily from a $99.7
million after-tax charge related to the impairment of the contract operations
and construction businesses of the discontinued operations. (See Notes D and I.)
LIQUIDITY AND CAPITAL RESOURCES
Capital Expenditures
Continuing Operations. We estimate that during 2002 we will spend,
excluding the allowance for funds used during construction, approximately $70
million for electric utility construction and $10 million for construction by
our other business lines. During the first nine months of 2002, we have spent
$60.4 million on capital expenditures, consisting of $51.3 million at Duquesne
Light, and $9.1 million on other.
Discontinued Operations. We estimate that during 2002 we will spend,
excluding the allowance for funds used during construction, approximately $53
million for water utility construction. During the first nine months of 2002, we
have spent $23.3 million in capital expenditures at AquaSource.
Asset Dispositions
Continuing Operations. In the first nine months of 2002, we sold a
significant portion of our remaining affordable housing portfolio, receiving
proceeds of approximately $17 million, which approximated book value. We
received $1.3 million from the sale of securities and recognized an after-tax
gain of $0.8 million. We received $1.3 million from the sale of a building and
recognized an after-tax gain of $0.3 million. We also received $2.3 million for
the sale of an electronic commerce investment, which approximated book value.
In July 2001, the Allegheny County Airport Authority purchased the
Pittsburgh International Airport energy facility from a DQE Enterprises
subsidiary, and entered into a 15-year operations and maintenance agreement
regarding the facility with DQE Energy Services. The transaction resulted in an
after-tax gain of $8.4 million.
AquaSource sold its bottled water assets in May 2001. The sale resulted in
an after tax loss of approximately $15 million, of which $10.0 million had been
recorded in December 2000. We also received $4.3 million for the sale of other
non-strategic assets.
Discontinued Operations. In the first nine months of 2002, we sold various
assets, including several wastewater facilities and real property and received
proceeds of approximately $6 million which approximated book value.
In addition, since July 2002 we have entered into agreements to sell more
than 85% of AquaSource's assets. (See Note I.)
Financing
On October 7, 2002, we issued 60,000 shares of our Preferred Stock, Series
A (Convertible), having an aggregate liquidation value of $6 million, in
connection with the settlement of the AquaSource litigation. (See "Legal
Proceedings.")
In September 2002, Duquesne Light converted approximately $98 million of
variable rate debt to fixed rate with maturities in 2011 and 2013, resulting in
a weighted average interest rate of 4.20%.
On August 5, 2002, we redeemed the following: (i) $10 million aggregate
principal amount of Duquesne Light's 8.20% first mortgage bonds due 2022 at a
redemption price of 104.51% of the principal amount thereof, and (ii) $100
million aggregate principal amount of Duquesne Light's 7 5/8% first mortgage
bonds due 2023 at a redemption price of 103.9458% of the principal amount
thereof.
On June 26, 2002 we issued 17,250,000 shares of common stock at $13.50 per
share in an underwritten public offering. This issuance was made under our April
5, 2002, shelf registration statement for up to
26
$500.0 million of various debt and equity securities. We received net proceeds,
after payment of underwriters discounts and commissions and other expenses, of
$223.4 million. We have used net proceeds to reduce approximately $171 million
principal amount of outstanding long-term debt (as discussed above) and
short-term debt, and have targeted the remaining net proceeds for general
corporate purposes, including payment of a deposit to the IRS toward any
adjustments in conjunction with certain structured lease transactions. (See Note
H.)
On April 15, 2002, Duquesne Light issued $200 million of 6.7% first
mortgage bonds due 2012. On April 30, 2002, Duquesne Light issued $100 million
of 6.7% first mortgage bonds due 2032. In each case it used the proceeds to call
and refund existing debt, including debt scheduled to mature in 2003 and 2004.
In January 2002, we refinanced $150 million of matured DQE Capital floating
rate notes through the issuance of commercial paper, primarily at Duquesne
Light. Cash generated from operations and equity offering proceeds was used to
redeem this debt in full, leaving no outstanding balance at September 30, 2002.
Liquidity
At September 30, 2002, we had a cash balance of $63.8 million.
In the first quarter of 2002, Moody's Investor Service, Standard & Poor's,
and Fitch Ratings assessed our short and long-term credit profiles. The ratings
reflect the agencies' opinion of our overall financial strength. Ratings impact
our ability to access capital markets for investment and capital requirements,
as well as the relative costs related to such liquidity capability. In general,
the agencies reduced our long-term credit ratings, although staying within the
range considered to be investment grade. The agencies maintained the existing
credit ratings for Duquesne Light's short-term debt. However Moody's and Fitch
reduced DQE Capital's short-term debt rating by one level, thereby restricting
DQE Capital from accessing the short-term commercial paper market. DQE Capital
is exploring alternative ways to fund its short-term liquidity needs. This
ratings downgrade does not limit our ability to access our revolving credit
facilities; it does, however, impact the cost of maintaining the credit
facilities and the cost of any new debt. These ratings are not a recommendation
to buy, sell or hold any securities of DQE or our subsidiaries, may be subject
to revisions or withdrawal by the agencies at any time, and should be evaluated
independently of each other and any other rating that may be assigned to our
securities.
We recently renewed our two 364-day revolving credit agreements, one for
$150 million at Duquesne Light and one for $140 million (previously $200
million) at DQE Capital. Both expire in October 2003. Interest rates on both
facilities can, in accordance with the option selected at the time of the
borrowing, be based on one of several indicators, including prime and Eurodollar
rates. Fees are based on the unborrowed amount of the commitment. At September
30, 2002 no borrowings were outstanding.
Both revolvers have "ratings triggers," pursuant to which changes in our
credit ratings will result in an inverse change in the fees and interest rates
charged under the facilities. The $140 million facility is subject to
cross-default if Duquesne Light defaults on the payment of $50 million or more,
including interest or premium, of any debt instrument.
Under our credit facilities, we are subject to financial covenants
requiring each of DQE and Duquesne Light to maintain a maximum
debt-to-capitalization ratio of 65.0%. In addition, DQE is required to maintain
a minimum cash coverage ratio of 2-to-1. At September 30, 2002 we were in
compliance with these covenants, having debt-to-total-capitalization ratios of
approximately 59.2% at DQE and approximately 56.2% at Duquesne Light, and a cash
coverage ratio of approximately 2.3-to-1 at DQE.
None of our long-term debt will mature before 2008. We expect to make
deposits with the IRS in connection with the income tax matter discussed in Note
H. (See "Outlook.")
At September 30, 2002, we had no commercial paper borrowings outstanding,
and $0.8 million of current debt maturities. During the quarter, the maximum
amount of bank loans and commercial paper borrowings outstanding was $35
million, the amount of average daily borrowings was $5.3 million, and the
weighted average daily interest rate was 2.16%.
Contractual Obligations and Commercial Commitments
As of September 30, 2002, we have certain contractual obligations and
commercial commitments that extend beyond this year, the principal amounts of
which are set forth in the following tables:
27
Payments Due By Period
- --------------------------------------------------------------------------------------------
(In Millions)
-------------------------------------------------
2002 2003 2004 2005 After Total
-------------------------------------------------
Long-Term Debt (a) $ -- $ 0.9 $ 1.4 $1.5 $1,082.8 $1,086.6
Notes Payable and Current Maturities (b) 0.8 -- -- -- -- 0.8
Capital Lease Obligations 0.1 0.4 0.4 0.5 1.4 2.8
Operating Leases (c) 2.1 8.7 9.2 7.5 70.5 98.0
- --------------------------------------------------------------------------------------------
Total Contractual Cash Obligations $3.0 $10.0 $11.0 $9.5 $1,154.7 $1,188.2
============================================================================================
(a) Excludes $13.4 million related to discontinued operations.
(b) Excludes $0.2 million related to discontinued operations.
(c) Excludes $0.1 million and $0.4 million in 2002 and 2003 related to
discontinued operations.
Other Commercial Commitments
- -----------------------------------------------------------------------------------------
(In Millions)
----------------------------------------------
2002 2003 2004 2005 After Total
----------------------------------------------
Revolving Credit Agreements (a) $ -- $290.0 $-- $-- $ -- $290.0
Standby Letters of Credit (a) 74.5 -- -- -- -- 74.5
Surety Bonds (b)
Commercial 125.3 -- -- -- -- 125.3
Contract 46.9 -- -- -- -- 46.9
Guarantees (See Note H) -- -- -- -- 74.5 74.5
- -----------------------------------------------------------------------------------------
Total Commercial Commitments $246.7 $290.0 $-- $-- $74.5 $611.2
=========================================================================================
(a) Revolving Credit Agreements and Letters of Credit are typically for a
364-day period and are renewed annually.
(b) Surety bonds are renewed annually. Some of the commercial bonds cover
regulatory and contractual obligations which exceed a one-year period.
Rate Matters
Competition and the Customer Choice Act
The Pennsylvania Electricity Generation Customer Choice and Competition Act
(Customer Choice Act) enables electric utility customers to purchase electricity
at market prices from a variety of electric generation suppliers. As of
September 30, 2002, approximately 76.6% of Duquesne Light's customers measured
on a KWH basis, and approximately 75.6% on a non-coincident peak load basis
received electricity through our provider of last resort service arrangement.
The remaining customers are provided with electricity through alternative
generation suppliers. The number of customers participating in our provider of
last resort service will fluctuate depending on market prices and the number of
alternative generation suppliers in the retail supply business.
Customers who select an alternative generation supplier pay for generation
charges set competitively by that supplier, and pay Duquesne Light a competitive
transition charge (discussed below) and/or transmission and distribution
charges. Electricity delivery (including transmission, distribution and customer
service) remains regulated in substantially the same manner as under historical
regulation.
In November 2001, the Pennsylvania Department of Revenue established an
increased revenue neutral reconciliation tax (RNR) in order to recover a current
shortfall that resulted from electricity generation deregulation. Duquesne Light
requested and received PUC approval to recover approximately $13 million of
costs it will incur in 2002 due to the RNR. (See "Legal Proceedings.")
Regional Transmission Organization
FERC Order No. 2000 calls on transmission-owning utilities such as Duquesne
Light to join regional transmission organizations (RTOs). Duquesne Light is
committed to ensuring a stable, plentiful supply of electricity for its
customers. Toward that end, Duquesne Light had planned to join the PJM West RTO.
However, on July 31, 2002, the FERC issued a series of proposals designed to
establish a standard market design and transmission service for interstate
electricity transactions, and extend the deadline for joining an RTO until
September 2004. Duquesne Light will continue to evaluate the FERC's proposals
and their impact on the possibility of joining an RTO.
28
Competitive Transition Charge
In its final restructuring order, the PUC determined that Duquesne Light
should recover most of the above-market costs of its generation assets,
including plant and regulatory assets, through the collection of the CTC from
electric utility customers. As of September 30, 2002, the CTC balance has been
fully collected for approximately 95% of Duquesne Light's customers, and 87% of
the KWH sales for the first nine months of 2002. The transition costs, as
reflected on the consolidated balance sheet, are being amortized over the same
period that the CTC revenues are being recognized.
For regulatory purposes, the unrecovered balance of transition costs was
approximately $32.6 million ($19.8 million net of tax) at September 30, 2002, on
which Duquesne Light is allowed to earn an 11.0% pre-tax return. A lower amount
is shown on the balance sheet due to the accounting for unbilled revenues.
Provider of Last Resort
Although no longer a generation supplier, as the provider of last resort
for all customers in its service territory, Duquesne Light must provide
electricity for any customer who does not choose an alternative generation
supplier, or whose supplier fails to deliver. As part of the generation asset
sale, a third party agreed to supply all of the electric energy necessary to
satisfy Duquesne Light's provider of last resort obligations during the CTC
collection period. Under POLR II, Duquesne Light has extended the arrangement
(and the PUC-approved rates for the supply of electricity) beyond the final CTC
collection through December 31, 2004. POLR II also permits Duquesne Light,
following CTC collection for each rate class, an average margin of 0.5 cents per
KWH supplied through this arrangement. Except for this margin, these agreements,
in general, effectively transfer to the supplier the financial risks and rewards
associated with Duquesne Light's provider of last resort obligations.
While there are certain safeguards in the provider of last resort
arrangements designed to mitigate losses in the event that the supplier defaults
on its performance under the arrangement, Duquesne Light may face the credit
risk of such a default. Contractually, Duquesne Light has various credit
enhancements that would become activated upon certain events. If the supplier
were to fail to deliver, Duquesne Light would have to contract with another
supplier and/or make purchases in the market at the time of default at a time
when market prices could be higher. While the Customer Choice Act provides
generally for provider of last resort supply costs to be borne by customers,
recent litigation suggests that it may not be clear whether Duquesne Light could
pass any costs in excess of the existing PUC-approved provider of last resort
prices on to its customers. Additionally, the supplier has recently been
downgraded by the rating agencies. Although we are following the situation
closely, our knowledge is limited to public disclosure, and we do not know
whether the downgrade could affect the supplier's ability to perform. Duquesne
Light also retains the risk that customers will not pay for the provider of last
resort generation supply. However, a component of Duquesne Light's delivery rate
is designed to cover the cost of a normal level of uncollectible accounts.
On October 25, 2002, Duquesne Light petitioned the PUC to issue a
declaratory order regarding a provision in its retail tariff that affects its
largest industrial customer. The supplier and Duquesne Light have interpreted
the tariff differently. The supplier's interpretation could increase the
customer's bill by approximately $7 to $9 million annually. Duquesne Light has
requested that the PUC affirm Duquesne Light's interpretation of the tariff
requirements. Duquesne Light retains the risk of recovering this increase from
the customer, should the customer refuse to pay. This risk is not included in
the "normal level" of uncollectible accounts described above.
Duquesne Light is preparing a post-2004 POLR supply plan to be filed with
the PUC in the near future. This plan would provide capped rates and offer
protection from electric market volatility for residential and small commercial
POLR customers. This plan continues to evolve as the wholesale power markets
continue to change. For example, given the interest many generating companies
have shown in potentially supplying long-term POLR service, we are no longer
actively exploring the development of a generating station. We are in the
process of evaluating various options and expect to complete our assessment
prior to the new filing. Our goal is to mitigate various risks associated with a
supply plan and to enhance shareholder value through a continuing earnings
stream from the core electric business.
Rate Freeze
In connection with the POLR II agreement described above, Duquesne Light
negotiated a rate freeze for generation, transmission and distribution rates.
The rate freeze fixes new generation rates through 2004 for retail customers who
take electricity under POLR II, and continues the transmission and distribution
rates for all customers at current levels through at least 2003. Under certain
circumstances, affected interests may file a complaint alleging that, under
these frozen rates, Duquesne Light has exceeded reasonable earnings, in which
case the PUC could make adjustments to rectify such earnings.
Discontinued Operations
As previously discussed, AquaSource is now reported as a discontinued
operation. (See Note I.)
In June 2000, AquaSource filed consolidated, statewide water and sewer rate
change applications with the Texas Natural Resource Conservation Commission
(TNRCC) and 17 municipalities. As previously reported, four municipalities
denied or altered the rate increase, AquaSource appealed, and
29
the parties have entered into a settlement agreement. The TNRCC entered its
final order on September 17, 2002 approving the settlement agreement reached by
all parties.
In March 2001, AquaSource also filed a rate increase petition with the
Indiana Utility Regulatory Commission (IURC) to increase water and sewer rates
for Utility Center, Inc., AquaSource's largest regulated subsidiary. Hearings
were held in January 2002. AquaSource remains engaged in discussions with the
IURC regarding the petition. Final resolution is anticipated in the fourth
quarter of 2002.
AquaSource is in the process of filing petitions requesting approval of the
sale of the investor-owned utilities with all the appropriate state public
utility commissions. Most such filings have been made.
Outlook
We continue to expect earnings, excluding any potential charges from asset
divestitures or other write-downs, to be $85 to $90 million for 2002 (comprised
of $77 to $81 million from continuing operations and $8 to $9 million from
AquaSource) and $95 to $100 million for 2003 (comprised of $84 to $88 million
from continuing operations and $11 to $12 million from AquaSource). Our earnings
projections reflect pension gains which have resulted from our historically
conservative investment and funding strategy. We expect these gains to decline
significantly by 2004, due to market conditions. Our 2003 projections also
include retirement of debt in anticipation of the AquaSource asset sale to PSC.
(See Note I.)
In connection with the income tax matter discussed in Note H, we expect to
deposit $105 million with the IRS ($55 million in 2002 and $50 million in 2003)
to be applied toward any adjustments which may ultimately be proposed.
We are receiving indications of interest for the purchase of AquaSource's
construction business, and anticipate a final sale by the end of 2002.
We have also received proposals for the purchase of all or part of our
propane business. Based on the proposals received to date, a decision to sell
this business in the near term would likely yield proceeds less than its
recorded value of $60 million at September 30, 2002. We cannot predict whether
any sales of this business will be completed, or when or at what price. Any sale
will be subject to board review and approval.
Future earnings will reflect a continued focus on recurring and sustainable
earnings through our Back-to-Basics strategy.
The foregoing "Outlook" section contains forward-looking statements, the
results of which may materially differ from those implied due to known and
unknown risks and uncertainties as discussed below.
. Projected DQE cash flow, net income, earnings, earnings growth,
capitalization, dividends and dividend payout ratio will depend on the
performance of our subsidiaries, the effectiveness of the divestiture
of non-core businesses, the implementation of our growth plan, the
timing of receipt of asset sale proceeds and board policy.
. Demand for and pricing of water, electric and telecommunications
utility services and landfill gas, changing market conditions and
weather conditions, could affect income and earnings levels at DQE and
each subsidiary.
. Duquesne Light's earnings will be affected by the number of customers
who choose to receive electric generation through POLR II, by final
PUC approval of its post-2004 POLR plan and by the continued
performance of the generation supplier.
. The ultimate structure of the post-2004 POLR plan will be subject to
PUC review and approval, as well as Duquesne Light's ability to
contract with suitable third-party suppliers.
. The timing of the various AquaSource asset sale closings, the use of
proceeds from the sales, purchase price adjustments, and the
accounting treatment of the disposition and the retained assets and
liabilities, may affect AquaSource's and DQE's earnings.
. The timing of the closing of the various AquaSource asset sales will
depend on the results of negotiations with the purchasing parties and
determinations by the local public utility commissions.
. Customer energy demand, fuel costs and plant operations could affect
DQE Energy Services' earnings.
. The outcome of the shareholder litigation initiated against DQE may
affect performance.
. The final resolution of the IRS' proposed adjustments regarding our
federal income tax liabilities could affect cash flows, and the size
and timing of payments on such adjustments.
. Earnings with respect to affordable housing investments, alternative
fuel operations and landfill gas will depend, in part, on the
continued viability of, and our compliance with the requirements for,
applicable federal tax credits.
. Market and business conditions, demand for services, and stock market
volatility may affect our ability to monetize non-core propane assets
and energy technology investments.
. The events of September 11, 2001 have created broad uncertainty in the
global economy, and we continue to assess the impact on our
businesses, including but not limited to DQE Financial.
30
. Overall performance by DQE and its affiliates could be affected by
economic, competitive, regulatory, governmental and technological
factors affecting operations, markets, products, services and prices,
as well as the factors discussed in our SEC filings made to date.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
Market risk represents the risk of financial loss that may impact our
consolidated financial position, results of operations or cash flows due to
adverse changes in market prices and rates.
We manage our interest rate risk by balancing our exposure between fixed
and variable rates, while attempting to minimize our interest costs. Currently,
our variable interest rate debt is approximately $320.1 million or 29.6% of
long-term debt. This variable rate debt is low-cost, tax-exempt debt. We also
manage our interest rate risk by retiring and issuing debt from time to time and
by maintaining a balance of short-term, medium-term and long-term debt. A 10%
increase in interest rates would have affected our variable rate debt
obligations by increasing interest expense by approximately $0.7 million for the
nine months ended September 30, 2002 and $1.2 million for the nine months ended
September 30, 2001. A 10% reduction in interest rates would have increased the
market value of our fixed-rate debt by approximately $51.8 million and $55.5
million as of September 30, 2002 and September 30, 2001. Such changes would not
have had a significant near-term effect on our future earnings or cash flows.
Item 4. Controls and Procedures.
Within the 90 days prior to the date of this report, management (including
our chief executive officer and principal financial officer) evaluated the
effectiveness of our "disclosure controls and procedures" (as defined in the
Securities Exchange Act of 1934, Rules 13a-14(c) and 15-d-14(c)). Management
concluded that, as of the evaluation date, our disclosure controls and
procedures were adequate and designed to ensure that material information
relating to us and our consolidated subsidiaries would be made known to
management by others within those entities. In addition, there were no
significant changes in our internal controls or in other factors that could
significantly affect our disclosure controls and procedures subsequent to the
evaluation date, including any corrective actions with regard to significant
deficiencies and material weaknesses.
----------
31
PART II. OTHER INFORMATION.
Item 1. Legal Proceedings.
AquaSource. In February 2001, 39 former and current employees of our
subsidiary AquaSource, Inc., all minority investors in AquaSource, commenced an
action against DQE, AquaSource and others in the District Court of Harris
County, Texas. The complaint alleged that the defendants fraudulently induced
the plaintiffs to agree to sell their AquaSource Class B stock back to
AquaSource by falsely promising orally that DQE would invest $1 billion or more
in AquaSource, which, plaintiffs allege, would have permitted them to realize
significant returns on their investments in AquaSource. The complaint also
alleged that the defendants mismanaged AquaSource, and thus decreased the value
of plaintiffs' AquaSource stock. Plaintiffs sought, among other relief, an order
rescinding their agreements to sell their stock back to AquaSource, an award of
actual damages not to exceed $100 million and exemplary damages not to exceed
$400 million.
In the first quarter of 2002, DQE and AquaSource filed counterclaims
alleging that 10 plaintiffs who held key AquaSource management positions engaged
in deceptive practices designed to obtain funding for acquisitions and to make
those acquisitions appear to meet certain return on investment requirements, and
that all plaintiffs were unjustly enriched by these wrongful actions. DQE,
AquaSource and AquaSource Utility, Inc. also filed a counterclaim against two
plaintiffs alleging claims for breach of contract, breach of warranty,
indemnification, fraud and unjust enrichment in connection with the acquisition
of various water and wastewater companies from these two plaintiffs.
The parties entered into a settlement agreement which became effective
October 7, 2002. The settlement is valued at approximately $22 million, and
includes cash, 60,000 shares of our Preferred Stock, Series A (Convertible), a
note receivable, and an AquaSource building in Houston together with the
furniture and fixtures currently in the building and one other piece of real
property in Houston. The building, furniture, fixtures and property were
transferred to the plaintiffs' designee. The plaintiffs provided all defendants
with a broad release of all claims arising out of the transactions that are the
subject of the litigation, as well as all claims relating to any plaintiff's
past employment with AquaSource. The plaintiffs also agreed not to solicit
AquaSource customers or employees through October 31, 2003.
The settlement provides that each holder of the preferred stock received in
the settlement has the option to sell all, but not less than all, of such
holder's shares of the preferred stock to us on the earlier to occur of (i) a
sale by us of all or substantially all of the stock or assets of AquaSource or
(ii) the two-year anniversary of the settlement effective date. The purchase
price of each share of preferred stock to be so purchased by us will be the $100
liquidation value, plus an amount equal to accrued dividends to the date of
payment. The purchase price will be payable entirely in cash or, at our
election, in common stock.
An estimated reserve for this matter was made at June 30, 2002. The final
settlement did not significantly affect our third quarter results of operations
or cash flows.
Shareholder Class Action. In October and November 2001, a number of
putative class action lawsuits were filed by purported shareholders of DQE
against DQE and David Marshall, DQE's former chairman, chief executive officer
and president, in the United States District Court for the Western District of
Pennsylvania. These cases were consolidated under the caption In re DQE, Inc.
Securities Litigation, Master File No. 01-1851 (W.D. Pa.), and the plaintiffs
filed a second consolidated amended complaint on April 15, 2002. The complaint
alleges violations of Section 10(b) of the Securities Exchange Act of 1934 (the
"Exchange Act") and Rule 10b-5 promulgated thereunder, and Section 12(a)(2) of
the Securities Act of 1933 (the "Securities Act"). The complaint also alleges
controlling person liability under Section 20(a) of the Exchange Act and Section
15 of the Securities Act. The complaint alleges that between December 6, 2000
and April 30, 2001, the defendants issued a number of materially false and
misleading statements concerning investments made by our subsidiary, DQE
Enterprises, and the impact that these investments would have on our current and
future financial results.
More particularly, the complaint alleges that DQE and Marshall stated their
expectation that certain companies in which DQE Enterprises had invested would
undertake initial public offerings of their shares, with the result that our
earnings would be positively impacted by the public market valuation of DQE
Enterprises' interests in these companies, but failed to disclose allegedly
adverse facts that made the possibility of successful public offerings of the
securities of these companies unlikely. The complaint seeks an award of
unspecified compensatory damages, and an order permitting class members who
purchased DQE shares through a dividend reinvestment plan to rescind those
32
purchases, pre- and post-judgment interest, attorneys' fees and expenses of
litigation and unspecified equitable and injunctive relief.
On May 24, 2002, we filed a motion on behalf of DQE and David Marshall,
seeking dismissal of the lawsuit. On October 17, 2002, the District Court denied
the motion.
Although we cannot predict the ultimate outcome of this case or estimate
the range of any potential loss that may be incurred in the litigation, we
believe that the lawsuit is without merit, strenuously deny all of the
plaintiffs' allegations of wrongdoing and believe we have meritorious defenses
to the plaintiffs' claims. We are vigorously defending this lawsuit.
Office of Consumer Advocate. Duquesne Light requested and received PUC
approval to recover approximately $13 million of costs it will incur in 2002 due
to the RNR. On November 19, 2001, the Pennsylvania Office of Consumer Advocate
(OCA) filed a complaint with the PUC, objecting to the recovery approval and
stating various matters, such as rate of return and offsetting savings, that
should be considered before allowing RNR recovery in excess of rate caps. An
initial hearing on the OCA's complaint was held May 2, 2002 before a PUC
administrative law judge, who denied the OCA's objections. However, on May 9,
2002, the PUC ordered that Duquesne Light's quarterly earnings may be considered
in the RNR proceedings. Additional hearings were held in July 2002. On August 8,
2002, the PUC voted to uphold dismissal of the OCA's case.
Proceedings regarding rates are discussed under "Rate Matters."
Item 5. Other Information.
The Sarbanes-Oxley Act of 2002, which became effective on July 30, 2002,
requires disclosure of any non-audit services performed by a company's auditor.
As previously disclosed in our 2001 Annual Report to Shareholders, our
independent public accountants provide non-audit, tax-related services.
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits:
Exhibit 3.1 - Bylaws of DQE, as amended and effective September 26, 2002.
Exhibit 10.1 - LLC Purchase Agreement by and among AquaSource, DQE,
and Southwest Water Company, dated as of September 14, 2002.
Exhibit 12.1 - Calculation of Ratio of Earnings to Fixed Charges and
Preferred and Preference Stock Dividend Requirements.
Exhibit 99.1 - Certification of Chief Executive Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
Exhibit 99.2 - Certification of Principal Financial Officer Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
b. We filed a Form 8-K on August 14, 2002, to report the submission to the SEC
of our principal executive and financial officers' statements under oath
regarding facts and circumstances relating to Exchange Act filings.
33
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant identified below has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
DQE, Inc.
----------------------------------------
(Registrant)
Date November 14, 2002 /s/ Frosina C. Cordisco
----------------------------------------
(Signature)
Frosina C. Cordisco
Vice President and Treasurer
(Principal Financial Officer)
Date November 14, 2002 /s/ Stevan R. Schott
----------------------------------------
(Signature)
Stevan R. Schott
Vice President and Controller
(Principal Accounting Officer)
34
CERTIFICATIONS
I, Morgan K. O'Brien, Chief Executive Officer and President of DQE, Inc.,
certify that:
1. I have reviewed this quarterly report on Form 10-Q of DQE, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Morgan K. O'Brien
----------------------------------------
Morgan K. O'Brien
Chief Executive Officer and President
35
I, Frosina C. Cordisco, Vice President and Treasurer of DQE, Inc., certify
that:
1. I have reviewed this quarterly report on Form 10-Q of DQE, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Frosina C. Cordisco
----------------------------------------
Frosina C. Cordisco
Vice President and Treasurer
(Principal Financial Officer)
36