UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 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 October 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to _______________
Commission file number: 000-24394
PENN OCTANE CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 52-1790357
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
77-530 ENFIELD LANE, BLDG. D, PALM DESERT, CALIFORNIA 92211
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Including Area Code: (760) 772-9080
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes No X
--- ---
The number of shares of Common Stock, par value $.01 per share, outstanding on
December 10, 2004 was 15,285,245.
1
PENN OCTANE CORPORATION
TABLE OF CONTENTS
ITEM PAGE NO.
---- --------
Part I 1. Financial Statements
Independent Certified Public Accountants' Review Report 3
Consolidated Balance Sheets as of October 31, 2004 (unaudited) 4-5
and July 31, 2004
Unaudited Consolidated Statements of Operations for the three months
ended October 31, 2004 and 2003 6
Unaudited Consolidated Statements of Cash Flows for the three months
ended October 31, 2004 and 2003 7
Notes to Consolidated Financial Statements (Unaudited) 8-21
2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 22-39
3. Quantitative and Qualitative Disclosures About Market Risk 39
4. Controls and Procedures 39
Part II 1. Legal Proceedings 40
2. Unregistered Sales of Equity Securities and Use of Proceeds 40
3. Defaults Upon Senior Securities 40
4. Submission of Matters to a Vote of Security Holders 40
5. Other Information 40
6. Exhibits and Reports on Form 8-K 40
Signatures 41
2
Independent Certified Public Accountants' Review Report
Board of Directors and Stockholders
Penn Octane Corporation
We have reviewed the consolidated balance sheet of Penn Octane Corporation and
subsidiaries (Company) as of October 31, 2004, and the related consolidated
statements of operations for the three months ended October 31, 2004 and 2003
and the consolidated statements of cash flows for the three months ended October
31, 2004 and 2003. These financial statements are the responsibility of the
Company's management.
We conducted our review in accordance with the standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with the
standards of the Public Company Accounting Oversight Board, the objective of
which is the expression of an opinion regarding the financial statements taken
as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to the financial statements referred to above for them to be in
conformity with United States generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheet of Penn Octane Corporation and Subsidiaries as of July 31, 2004, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for the year then ended (not presented herein); and in our report dated
October 5, 2004, we expressed an unqualified opinion on those consolidated
financial statements. In our opinion, the information set forth in the
accompanying consolidated balance sheet as of July 31, 2004, is fairly stated.
Our auditor's report on the Company's financial statements as of July 31, 2004
included an explanatory paragraph referring to the matters discussed in Note S
of those financial statements which raised substantial doubt about the Company's
ability to continue as a going concern. As indicated in Note K of the
accompanying unaudited interim financial statements, conditions continue to
exist which raise substantial doubt about the Company's ability to continue as a
going concern.
/s/ BURTON MCCUMBER & CORTEZ, L.L.P.
Brownsville, Texas
December 10, 2004
3
PART I
ITEM 1.
PENN OCTANE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
October 31,
2004 July 31,
(Unaudited) 2004
------------- -----------
Current Assets
Cash $ 511,558 $ 384,074
Restricted cash 3,266,465 6,314,071
Trade accounts receivable (less allowance for doubtful accounts of $0) 9,956,172 6,207,067
Inventories 4,263,516 1,632,992
Prepaid expenses and other current assets 202,349 210,520
------------- -----------
Total current assets 18,200,060 14,748,724
Property, plant and equipment - net 16,156,474 16,398,280
Lease rights (net of accumulated amortization of $764,779 and $753,330 at
October 31, 2004 and July 31, 2004) 389,260 400,709
Other non-current assets 28,539 29,639
------------- -----------
Total assets $ 34,774,333 $31,577,352
============= ===========
The accompanying notes and accountants' report are an integral part of these statements.
4
PENN OCTANE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS - CONTINUED
LIABILITIES AND STOCKHOLDERS' EQUITY
October 31,
2004 July 31,
(Unaudited) 2004
--------------- ---------------
Current Liabilities
Current maturities of long-term debt $ 162,694 $ 162,694
Revolving line of credit 1,003,790 2,688,553
LPG and fuel products trade accounts payable 12,125,963 7,432,728
Other accounts payable 1,759,942 1,784,643
US and foreign taxes payable 29,480 5,194
Accrued liabilities 1,374,530 1,123,979
--------------- ---------------
Total current liabilities 16,456,399 13,197,791
Long-term debt, less current maturities 1,752,183 1,729,202
Minority interest in Rio Vista Energy Partners L.P. 14,448,870 -
Commitments and contingencies - -
Stockholders' Equity
Series A - Preferred stock-$.01 par value, 5,000,000 shares authorized;
No shares issued and outstanding at October 31, 2004 and July 31, 2004 - -
Series B - Senior preferred stock-$.01 par value, $10 liquidation value,
5,000,000 shares authorized; No shares issued and outstanding at October
31, 2004 and July 31, 2004 - -
Common stock - $.01 par value, 25,000,000 shares authorized;
15,285,245 shares issued and outstanding at October 31, 2004 and July
31, 2004 152,852 152,852
Additional paid-in capital 28,501,669 28,460,972
Notes receivable from an officer of the Company and another party for
exercise of warrants, less reserve of $468,693 at October 31, 2004 and
July 31, 2004 ( 2,728,000) ( 2,728,000)
Accumulated deficit ( 23,809,640) ( 9,235,465)
--------------- ---------------
Total stockholders' equity 2,116,881 16,650,359
--------------- ---------------
Total liabilities and stockholders' equity $ 34,774,333 $ 31,577,352
=============== ===============
The accompanying notes and accountants' report are an integral part of these statements.
5
PENN OCTANE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended
------------------------------
October 31, October 31,
2004 2003
-------------- --------------
Revenues $ 65,512,588 $ 38,549,107
Cost of goods sold 63,521,381 36,483,177
-------------- --------------
Gross profit 1,991,207 2,065,930
Selling, general and administrative expenses
Legal and professional fees 239,271 761,869
Salaries and payroll related expenses 970,668 501,415
Other 816,286 275,915
-------------- --------------
2,026,225 1,539,199
Loss on sale of CNG assets - ( 500,000)
-------------- --------------
Operating income (loss) ( 35,018) 26,731
Other income (expense)
Interest and LPG and Fuel Products financing
expense ( 356,843) ( 375,586)
Interest income 9,080 5,339
Minority interest in loss of Rio Vista Energy
Partners L.P. 234,097 -
Other income - 210,000
-------------- --------------
Loss before taxes ( 148,684) ( 133,516)
Provision for income tax 86,396 25,000
-------------- --------------
Net loss $( 235,080) $( 158,516)
============== ==============
Net income (loss) per common share $( 0.02) $( 0.01)
============== ==============
Net income (loss) per common share assuming
dilution $( 0.02) $( 0.01)
============== ==============
Weighted average common shares outstanding 15,285,245 15,298,261
============== ==============
The accompanying notes and accountants' report are an integral part of these statements.
6
PENN OCTANE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Three Months Ended
--------------------------------
October 31, October 31,
2004 2003
--------------- ---------------
Cash flows from operating activities:
Net loss $( 235,080) $ (158,516)
Adjustments to reconcile net income to net cash (used in) provided
by operating activities:
Depreciation and amortization 241,806 222,060
Amortization of lease rights 11,449 11,449
Non-employee stock based costs and other - 31,217
Amortization of loan discount related to detachable warrants 24,281 51,081
Loss on sale of CNG assets - 500,000
Stock based compensation 384,574 -
Minority interest in Rio Vista Energy Partners L.P. ( 234,097) -
Changes in current assets and liabilities:
Trade accounts receivable ( 3,749,105) ( 3,924,161)
Inventories ( 2,630,524) 13,572
Prepaid and other current assets 8,171 26,358
LPG and Fuel Products trade accounts payable 4,693,235 2,716,488
Other accounts payable and accrued liabilities 225,844 ( 73,991)
US and Foreign taxes payable 24,286 25,000
--------------- ---------------
Net cash used in operating activities (1,235,160) ( 559,443)
Cash flows from investing activities:
Capital expenditures - ( 94,999)
(Increase) decrease in other non-current assets 1,100 2,531
--------------- ---------------
Net cash provided by (used in) investing activities 1,100 ( 92,468)
Cash flows from financing activities:
(Increase) decrease in restricted cash 3,047,606 852,474
Revolving credit facilities ( 1,684,763) -
Issuance of common stock - 80,625
Issuance of debt - 60,000
Reduction in debt ( 1,299) ( 320,226)
--------------- ---------------
Net cash provided by financing activities 1,361,544 672,873
--------------- ---------------
Net increase in cash 127,484 20,962
Cash at beginning of period 384,074 71,064
--------------- ---------------
Cash at end of period $ 511,558 $ 92,026
=============== ===============
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest and LPG and Fuel Products financing $ 326,051 $ 325,915
=============== ===============
Supplemental disclosures of noncash transactions:
Equity-common stock and warrants issued and other $ 40,699 $ -
=============== ===============
Minority interest in Rio Vista Energy Partners L.P. $ 14,339,092 $ -
=============== ===============
The accompanying notes and accountants' report are an integral part of these statements.
7
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE A - ORGANIZATION
Penn Octane Corporation, formerly known as International Energy Development
Corporation (International Energy), was incorporated in Delaware in August
1992. Penn Octane Corporation (Penn Octane) and its consolidated
subsidiaries are hereinafter referred to as the Company. The Company has
been principally engaged in the purchase, transportation and sale of
liquefied petroleum gas (LPG). The Company owns and operates a terminal
facility in Brownsville, Texas (Brownsville Terminal Facility) and owns a
LPG terminal facility in Matamoros, Tamaulipas, Mexico (Matamoros Terminal
Facility) and approximately 23 miles of pipelines (US - Mexico Pipelines)
which connect the Brownsville Terminal Facility to the Matamoros Terminal
Facility. The Company has a long-term lease agreement for approximately 132
miles of pipeline (Leased Pipeline) which connects ExxonMobil Corporation's
(Exxon) King Ranch Gas Plant in Kleberg County, Texas and Duke Energy's La
Gloria Gas Plant in Jim Wells County, Texas, to the Company's Brownsville
Terminal Facility. In addition, the Company has access to a twelve-inch
pipeline (ECCPL), which connects from Exxon's Viola valve station in Nueces
County, Texas to the inlet of the King Ranch Gas Plant as well as existing
and other potential propane pipeline suppliers which have the ability to
access the ECCPL. In connection with the Company's lease agreement for the
Leased Pipeline, the Company may access up to 21,000,000 gallons of
storage, located in Markham, Texas (Markham), as well as other potential
propane pipeline suppliers, via approximately 155 miles of pipeline located
between Markham and the Exxon King Ranch Gas Plant.
The Company commenced commercial operations for the purchase, transport and
sale of LPG in the fiscal year ended July 31, 1995, upon construction of
the Brownsville Terminal Facility. The primary market for the Company's LPG
is the northeastern region of Mexico, which includes the states of
Coahuila, Nuevo Leon and Tamaulipas. Since operations commenced, the
Company's primary customer for LPG has been P.M.I. Trading Limited (PMI).
PMI is a subsidiary of Petroleos Mexicanos, the state-owned Mexican oil
company, which is commonly known by its trade name "PEMEX." PMI is the
exclusive importer of LPG into Mexico. The LPG purchased by PMI from the
Company is sold to PEMEX which distributes the LPG purchased from PMI into
the northeastern region of Mexico. Sales of LPG to PMI accounted for
approximately 50.5% of the Company's total revenues and 75.4% of the
Company's total LPG revenues for the three months ended October 31, 2004.
The Company's gross profit is dependent on sales volume of LPG to PMI,
which fluctuates in part based on the seasons. The demand for LPG is
strongest during the winter season.
During June 2004, the Company began operations as a reseller of gasoline
and diesel fuel (Fuel Products). The Company sells Fuel Products (Fuel
Sales Business) through transactional, bulk and/or rack transactions.
Typical transactional and bulk sales are made based on a predetermined net
spread between the purchase and sales price over posted monthly variable
prices and/or daily spot prices. Rack sales transactions are based on
variable sale prices charged by the Company which are tied to posted daily
spot prices and purchase costs which are based on a monthly average or 3
day average based on posted prices. The Company pays pipeline and terminal
fees based on regulated rates.
The Company has the ability to access to certain pipeline and terminal
systems located in California, Arizona, Nevada and Texas, where it is able
to deliver its Fuel Products.
For bulk and transactional sales, the Company enters into individual sales
contracts for each sale. Rack sales are subject to credit limitations
imposed on each individual buyer by the Company. The Company has several
supply contracts for each of the Fuel Products it sells. The supply
contracts are for annual periods with flexible volumes but they may be
terminated sooner by the supplier if the Company consistently fails to
purchase minimum volumes of Fuel Products.
8
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE A - ORGANIZATION - CONTINUED
On September 30, 2004, Penn Octane Corporation (Penn Octane) completed a
series of transactions involving (i) the transfer of substantially all of
its owned pipeline and terminal assets in Brownsville and Matamoros to its
wholly owned subsidiary Rio Vista Operating Partnership L.P. and its
subsidiaries (RVOP) (ii) transferred its 99.9% interest in RVOP to its
wholly owned subsidiary Rio Vista Energy Partners L.P. and its subsidiaries
(Rio Vista) and (iii) distributed all of its limited partnership interest
(Common Units) in Rio Vista to its common stockholders (Spin-Off),
resulting in Rio Vista becoming a separate public company. The Common Units
represented 98% of Rio Vista's outstanding units. The remaining 2% of such
units, which is the general partner interest, is owned and controlled by
Rio Vista GP LLC (General Partner), a wholly owned subsidiary of Penn
Octane, and the General Partner is responsible for the management of Rio
Vista. Accordingly the Company has control of Rio Vista by virtue of its
ownership and related voting control of the General Partner and therefore,
Rio Vista is consolidated with the Company and the interests of the limited
partners are classified as minority interests in the Company's consolidated
financial statements. Subsequent to the Spin-Off, Rio Vista sells LPG
directly to PMI and purchases LPG from Penn Octane under a long-term supply
agreement. The purchase price of the LPG from Penn Octane is determined
based on the cost of LPG under Penn Octane's LPG supply agreements with its
suppliers, other direct costs related to PMI sales and a formula that takes
into consideration operating costs of Penn Octane and Rio Vista.
BASIS OF PRESENTATION
-----------------------
The accompanying consolidated financial statements include the Company and
its United States subsidiaries including Penn Octane International, L.L.C.,
PennWilson CNG, Inc. (PennWilson) and Penn CNG Holdings, Inc. and Rio Vista
and its US and Mexican subsidiaries, Penn Octane de Mexico, S. de R.L. de
C.V. (PennMex), Termatsal, S. de R.L. de C.V. (Termatsal) and Tergas, S.A.
de C.V. (Tergas), a consolidated affiliate, and its other inactive Mexican
subsidiaries. All significant intercompany accounts and transactions are
eliminated.
The unaudited consolidated balance sheet as of October 31, 2004, the
unaudited consolidated statements of operations for the three months ended
October 31, 2004 and 2003 and the unaudited consolidated statements of cash
flows for the three months ended October 31, 2004 and 2003, have been
prepared by the Company without audit. In the opinion of management, the
unaudited consolidated financial statements include all adjustments (which
include only normal recurring adjustments) necessary to present fairly the
unaudited consolidated financial position of the Company as of October 31,
2004, the unaudited consolidated results of operations for the three months
ended October 31, 2004 and 2003 and the unaudited consolidated statement of
cash flows for the three months ended October 31, 2004 and 2003.
Certain information and footnote disclosures normally included in
consolidated financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been
omitted. These unaudited consolidated financial statements should be read
in conjunction with the consolidated financial statements and notes thereto
included in the Company's Annual Report on Form 10-K for the fiscal year
ended July 31, 2004.
Certain reclassifications have been made to prior period balances to
conform to the current presentation. All reclassifications have been
consistently applied to the periods presented.
9
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE B - INCOME (LOSS) PER COMMON SHARE
Income (loss) per share of common stock is computed on the weighted average
number of shares outstanding. During periods in which the Company incurs
losses, giving effect to common stock equivalents is not presented as it
would be antidilutive.
The following tables present reconciliations from income (loss) per common
share to income (loss) per common share assuming dilution:
For the three months ended October 31, 2004
----------------------------------------------------
Income (Loss) Shares Per-Share
(Numerator) (Denominator) Amount
------------------ --------------- ---------------
Net income (loss) $( 235,080)
BASIC EPS
Net income (loss) available to common
stockholders ( 235,080) 15,285,245 $( 0.02)
===============
EFFECT OF DILUTIVE SECURITIES
Warrants - -
DILUTED EPS
Net income (loss) available to common
stockholders N/A N/A N/A
For the three months ended October 31, 2004
----------------------------------------------------
Income (Loss) Shares Per-Share
(Numerator) (Denominator) Amount
------------------ --------------- ---------------
Net income (loss) $( 158,516)
BASIC EPS
Net income (loss) available to common
stockholders ( 158,516) 15,298,261 $( 0.01)
===============
EFFECT OF DILUTIVE SECURITIES
Warrants - -
DILUTED EPS
Net income (loss) available to common N/A N/A N/A
stockholders
10
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE C - STOCK-BASED COMPENSATION
The Company accounts for stock option plans in accordance with the
provisions of APB No. 25, "Accounting for Stock Issued to Employees", and
related interpretations which recognizes compensation expense on the grant
date if the current market price of the stock exceeds the exercise price.
Had compensation cost related to the warrants granted to employees been
determined based on the fair value at the grant dates, consistent with the
provisions of SFAS 123, the Company's pro forma net income (loss), and net
income (loss) per common share would have been as follows:
Three Months Ended
----------------------------
October 31, October 31,
2004 2003
------------- -------------
Net income (loss), as reported $( 235,080) $( 158,516)
Add: Stock-based employee compensation cost expense
included in reported net income (loss), net of related tax
effects 6,878 -
Less: Total stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects ( 316,238) ( 52,914)
------------- -------------
Net income (loss), pro forma $( 544,440) $( 211,430)
============= =============
Net income (loss) per common share, as reported $( 0.02) $( 0.01)
============= =============
Net income (loss) per common share, pro forma $( 0.04) $( 0.01)
============= =============
Net income (loss) per common share assuming dilution, as
reported $( 0.02) $( 0.01)
============= =============
Net income (loss) per common share assuming dilution,
pro forma $( 0.04) $( 0.01)
============= =============
The following assumptions were used for grants of warrants to employees in
the three months ended October 31, 2004, to compute the fair value of the
warrants using the Black-Scholes option-pricing model; dividend yield of
0%; expected volatility of 63%, 58% and 37%; risk free interest rate of
3.52% and 3.09% and expected lives of 5 years, 1.75 years and 3 years.
The following assumptions were used for grants of warrants to employees in
the three months ended October 31, 2003, to compute the fair value of the
warrants using the Black-Scholes option-pricing model; dividend yield of
0%; expected volatility of 79%; risk free interest rate of 1.81% and
expected lives of 5 years.
11
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE D - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following:
October 31, July 31,
2004 2004
--------------- ---------------
LPG:
Midline pump station (b) $ 2,326,985 $ 2,326,985
Brownsville Terminal Facility: (a)
Building 173,500 173,500
Terminal facilities 3,631,207 3,631,207
Tank Farm 373,945 373,945
Leasehold improvements 302,657 302,657
Equipment 226,285 226,285
Truck 25,968 25,968
--------------- ---------------
7,060,547 7,060,547
--------------- ---------------
US - Mexico Pipelines and Matamoros Terminal
Facility: (a)
U.S. Pipelines and Rights of Way 6,775,242 6,775,242
Mexico Pipelines and Rights of Way 993,300 993,300
Matamoros Terminal Facility 5,874,781 5,874,781
Land 856,358 856,358
--------------- ---------------
14,499,681 14,499,681
--------------- ---------------
Total LPG 21,560,228 21,560,228
--------------- ---------------
Other:
Office equipment (b) 106,953 106,953
Software (b) 77,519 77,590
--------------- ---------------
184,472 184,543
--------------- ---------------
21,744,700 21,744,771
Less: accumulated depreciation and amortization ( 5,588,226) ( 5,346,491)
--------------- ---------------
$ 16,156,474 $ 16,398,280
=============== ===============
(a) Rio Vista assets
(b) Penn Octane and Subsidiaries other than Rio
Vista
Property, plant and equipment, net of accumulated depreciation, includes
$5,795,776 and $5,870,750 of costs, located in Mexico at October 31, 2004
and July 31, 2004, respectively.
12
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE E - INVENTORIES
Inventories are valued at the lower of cost or market (LCM) and consist of
the following:
October 31, 2004 July 31, 2004
--------------------- ---------------------
Gallons LCM Gallons LCM
--------- ---------- --------- ----------
LPG:
Leased Pipeline 1,175,958 $1,082,409 1,175,958 $ 887,815
Brownsville Terminal Facility,
Matamoros Terminal Facility
and railcars 425,419 391,576 257,665 194,530
Markham Storage and other 1,886,555 1,736,477 - -
--------- ---------- --------- ----------
3,487,932 3,210,462 1,433,623 1,082,345
========= =========
Fuel Products 702,817 1,053,054 433,566 550,647
========= ---------- ========= ----------
$4,263,516 $1,632,992
========== ==========
NOTE F - DEBT OBLIGATIONS
Debt consists of the following:
October 31, July 31,
2004 2004
------------ ----------
Noninterest-bearing note payable, discounted at 7%, for legal services;
due in February 2002. 137,500 137,500
Restructured Notes and $280,000 Notes 1,695,736 1,671,456
Other debt. 81,641 82,939
------------ ----------
Total debt 1,914,877 1,891,895
Less: Current maturities 162,694 162,694
Short term debt - -
------------ ----------
Long-term debt $ 1,752,183 $1,729,201
============ ==========
EXTENSION OF CERTAIN OF THE NEW ACCEPTING NOTEHOLDERS' NOTES, ADDITIONAL
NOTE AND $250,000 NOTE TOTALING $1,525,000 (COLLECTIVELY THE RESTRUCTURED
NOTES)
On January 16, 2004, the Restructured Notes which were due on December 15,
2003 were renewed and extended (Restructuring). In connection with the
Restructuring, the due date of the Restructured Notes was extended to
December 15, 2005. The Restructured Notes can be repaid at any time without
penalty. Annual interest on the Restructured Notes is 16.5% and the Company
also agreed to pay a fee of 1.5% on any principal balance of the
Restructured Notes outstanding at the end of each quarterly period,
beginning December 15, 2003. Interest and fees are payable quarterly
beginning March 15, 2004.
In addition, the Company agreed to extend the expiration date on
outstanding warrants to purchase common stock of Penn Octane held by
holders of the Restructured Notes until December 15, 2008 and agreed to
issue new warrants to purchase Rio Vista Common Units in an amount equal to
2,500 warrants for each $100,000 of Restructured Notes and an additional
2,500 warrants in Rio Vista for each $100,000 of Restructured Notes
outstanding at December 15, 2004 (Rio Vista Warrants). The Rio Vista
Warrants will expire three years from the date of the Spin-Off (see note R)
and the exercise price will be determined based on a formula whereby the
annualization of the first quarterly distribution will represent a 20%
yield on the exercise price. In addition, the Company agreed to issue an
additional 37,500 warrants to purchase shares of common stock of Penn
Octane to certain holders of the Restructured Notes.
13
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE F - DEBT OBLIGATIONS - CONTINUED
EXTENSION OF CERTAIN OF THE NEW ACCEPTING NOTEHOLDERS' NOTES, ADDITIONAL
NOTE AND $250,000 NOTE TOTALING $1,525,000 (COLLECTIVELY THE RESTRUCTURED
NOTES) - CONTINUED
Certain holders of promissory notes totaling approximately $280,000 of
principal due December 15, 2003 which did not agree to the Restructuring
(Declining Noteholders) were paid by the Company. In connection with
amounts due to the Declining Noteholders, the Company issued $280,000 of
promissory notes ($280,000 Notes). The terms of the $280,000 Notes are
substantially similar to the Restructured Notes, except that the holders of
the $280,000 Notes were not entitled to receive any warrants to purchase
shares of common stock of Penn Octane.
The holders of the Restructured Notes and $280,000 Notes consented to the
Spin-Off of Rio Vista provided that (1) the assets of Penn Octane
transferred to Rio Vista continue to be pledged as collateral for payment
of those notes, (2) Rio Vista guarantees Penn Octane's obligations under
the notes and (3) Rio Vista be prohibited from making any distributions in
the event that Penn Octane is in default under the Restructured Notes and
$280,000 Notes.
In connection with the Restructured Notes and $280,000 Notes, Philadelphia
Brokerage Corporation (PBC) acted as placement agent and received a fee
equal to 1.5% of the Restructured Notes and $280,000 Notes. PBC also
received warrants to purchase 10,000 units in Rio Vista and will receive an
additional 10,000 warrants to purchase 10,000 units in Rio Vista if the
Restructured Notes and $280,000 Notes are not paid by December 15, 2004.
The terms of the warrants are the same as the Rio Vista Warrants.
In connection with the issuance of the new warrants of Penn Octane and the
extension of the warrants of Penn Octane, the Company recorded a discount
of $194,245 related to the fair value of the newly issued, modified
warrants and including fees of $27,075 of which $84,982 has been amortized
through October 31, 2004. The Company will record an additional discount
related to the Rio Vista warrants issued to the holders of the Restructured
Notes and $280,000 Notes when the Company is able to determine the fair
value, if any (see above).
Jerome Richter, Chief Executive Officer of Penn Octane continues to provide
collateral to the Restructured Notes and the $280,000 Notes noteholders
with 2,000,000 shares of common stock of Penn Octane owned by him. As a
result of the Spin-Off, he is also required to provide as collateral
250,000 Common Units of Rio Vista owned by him.
14
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE G - STOCKHOLDERS' EQUITY
COMMON STOCK
-------------
The Company routinely issues shares of its common stock for cash, the
exercise of warrants, in payment of notes and other obligations and to
settle lawsuits.
STOCK WARRANTS
---------------
The Company applies APB 25 for warrants granted to the Company's employees
and to the Company's Board of Directors serving in the capacity as
directors and SFAS 123 for warrants issued to acquire goods and services
from non-employees.
In connection with warrants previously issued by the Company, certain of
these warrants contain a call provision whereby the Company has the right
to purchase the warrants for a nominal price if the holder of the warrants
does not elect to exercise the warrants during the call provision period.
On September 30, 2004, pursuant to the terms of an employment agreement
dated as of May 13, 2003 with Richard Shore, Jr., President of Penn Octane,
the Company issued warrants to purchase 763,737 shares of Penn Octane's
common stock at an exercise price of $1.14 per share. The warrants expire
on July 10, 2006. Based on the provisions of APB 25, no compensation
expense was recorded.
BOARD COMPENSATION PLAN (BOARD PLAN)
In connection with the Penn Octane Board Plan, during August 2004 the Board
granted warrants to purchase 20,000 shares of common stock of Penn Octane
at exercise prices of $1.93 and $1.94 per share to outside directors. The
warrants expire in August 2009. Based on the provisions of APB 25, no
compensation expense was recorded for these warrants.
In connection with the Penn Octane Board Plan, during November 2004 the
Board granted warrants to purchase 10,000 shares of common stock of Penn
Octane at exercise price of $1.30 per share to an outside director. The
warrants expire in November 2009. Based on the provisions of APB 25, no
compensation expense was recorded for these warrants.
15
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE H - OPTIONS AND WARRANTS OF RIO VISTA
GENERAL PARTNER OPTIONS
Penn Octane's 100% interest in the General Partner is expected to be
decreased to 50% as a result of the exercise by Shore Capital LLC (Shore
Capital) an affiliate of Mr. Shore, and Mr. Richter of options to each
acquire 25% of the General Partner (General Partner Options). Mr. Shore and
Mr. Richter are each members of the board of directors of Penn Octane and
the board of managers of the General Partner. It is anticipated that Mr.
Richter and Shore Capital will exercise their General Partner Options in
the near future. The exercise price for each option is approximately
$82,000. Based on the provisions of APB 25, the Company recorded
approximately $41,000 of compensation cost related to these options. Penn
Octane will retain voting control of the General Partner pursuant to a
voting agreement.
COMMON UNIT WARRANTS
In connection with Mr. Shore's employment agreement with Penn Octane, Shore
Capital received warrants to acquire 97,415 common units of Rio Vista at
$8.47 per unit. Based on the provisions of APB 25, Rio Vista recorded
$343,875 of compensation cost related to these warrants on October 1, 2004,
the initial exercise date. The warrants expire on July 10, 2006.
NOTE I - COMMITMENTS AND CONTINGENCIES
CREDIT FACILITY, LETTERS OF CREDIT AND OTHER
As of October 31, 2004, Penn Octane had a $15,000,000 credit facility
(increased to $20,000,000 on November 12, 2004) with RZB Finance, LLC (RZB)
for demand loans and standby letters of credit (RZB Credit Facility) to
finance Penn Octane's purchases of LPG and Fuel Products in connection with
Penn Octane's Fuel Sales Business. The RZB Credit facility is an
uncommitted facility under which the letters of credit have an expiration
date of no more than 90 days and the facility is reviewed annually at March
31. In connection with the RZB Credit Facility, the Company granted RZB a
security interest and assignment in any and all of the Company's accounts,
inventory, real property, buildings, pipelines, fixtures and interests
therein or relating thereto, including, without limitation, the lease with
the Brownsville Navigation District of Cameron County (District) for the
land on which the Company's Brownsville Terminal Facility is located, the
Pipeline Lease, and in connection therewith entered into leasehold deeds of
trust, security agreements, financing statements and assignments of rent.
Under the RZB Credit Facility, the Company may not permit to exist any
subsequent lien, security interest, mortgage, charge or other encumbrance
of any nature on any of its properties or assets, except in favor of RZB,
without the consent of RZB. After the Spin-Off and transfer of assets to
Rio Vista, RZB continues to retain a security interest in the transferred
assets.
Under the RZB Credit Facility, the Company is required to pay a fee with
respect to each letter of credit thereunder in an amount equal to the
greater of (i) $500, (ii) 2.5% of the maximum face amount of such letter of
credit, or (iii) such higher amount as may be agreed to between the Company
and RZB. Any loan amounts outstanding under the RZB Credit Facility shall
accrue interest at a rate equal to the rate announced by the JPMorgan Chase
Bank as its prime rate (4.75% at October 31, 2004) plus 2.5%. Pursuant to
the RZB Credit Facility, RZB has sole and absolute discretion to limit or
terminate its participation in the RZB Credit Facility and to refrain from
making any loans or issuing any letters of credit thereunder. RZB also has
the right to demand payment of any and all amounts outstanding under the
RZB Credit Facility at any time. In addition to the fees described above,
the Company is required to pay RZB annual fees of $50,000.
16
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE I - COMMITMENTS AND CONTINGENCIES - CONTINUED
CREDIT FACILITY, LETTERS OF CREDIT AND OTHER - CONTINUED
Based on current minimum purchase commitments under the Company's LPG
supply agreements and current LPG prices, the amount available to finance
Fuel Products and LPG purchases in excess of current minimum purchase
commitments is limited to current volumes and therefore the ability of the
Company to grow the Fuel Sales Business is dependent on future increases in
its RZB Credit Facility or other sources of financing, the reduction of LPG
supply commitments and/or the reduction in LPG or Fuel Products prices.
Under the terms of the RZB Credit Facility, either Penn Octane or Rio Vista
is required to maintain net worth of a minimum of $9,000,000 ($10,000,000
effective November 12, 2004).
Mr. Richter has personally guaranteed all of Penn Octane's payment
obligations with respect to the RZB Credit Facility.
In connection with the Company's purchases of LPG and Fuel Products,
letters of credit are issued based on anticipated purchases. Outstanding
letters of credit for LPG and Fuel Products at October 31, 2004 totaled
approximately $16,300,000 which represents October 2004 purchases.
In connection with the Company's purchase of LPG and Fuel Products, under
the RZB Credit Facility, assets related to product sales (Assets) are
required to be in excess of borrowings and commitments (including
restricted cash of approximately $2,502,000 at October 31, 2004). At
October 31, 2004, the Company's borrowings and commitments were less than
the amount of the Assets.
In connection with the Company's Fuel Sales Business, the Company has
issued bonds totaling $662,000 to the states of California, Nevada, Arizona
and Texas (Bonds) to secure payments of excise and other taxes collected
from customers in connection with sales of Fuel Products. The Bonds are
partially secured by letters of credit totaling $452,600. At October 31,
2004, such taxes of approximately $542,000 were due. In addition, in
connection with the Fuel Sales Business, the Company issued a letter of
credit of $284,000 in connection with the Company's use of pipeline and
terminal systems from a third party. The letters of credit issued have all
been secured by cash in the amount of $736,600 which is included in
restricted cash in the Company's balance sheet at October 31, 2004.
LPG and Fuel Products financing expense associated with the RZB Credit
Facility totaled $213,862 and $188,469 for the three months ended October
31, 2004 and 2003.
DISTRIBUTIONS OF AVAILABLE CASH
All unitholders, including the General Partner, have the right to receive
distributions of "available cash" as defined in the partnership agreement
(Agreement) from Rio Vista in an amount equal to the minimum distribution
of $0.25 per quarter per unit, plus any arrearages in the payment of the
minimum quarterly distribution on the units from prior quarters. The
distributions are to be paid 45 days after the end of each calendar
quarter. However, Rio Vista is prohibited from making any distributions to
unitholders if it would cause an event of default, or an event of default
is existing, under any obligation of Penn Octane which Rio Vista has
guaranteed.
Cash distributions from Rio Vista will be shared by the holders of the
common units and the General Partner Units as described in the Agreement
based on a formula whereby the General Partner will receive
disproportionately more distributions per unit than the holders of the
common units as annual cash distributions exceed certain milestones.
17
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE I - COMMITMENTS AND CONTINGENCIES - CONTINUED
PARTNERSHIP TAX TREATMENT
Rio Vista is not a taxable entity (see below) and incurs no federal income
tax liability. Instead, each unitholder of Rio Vista is required to take
into account that unitholder's share of items of income, gain, loss and
deduction of Rio Vista in computing that unitholder's federal income tax
liability, even if no cash distributions are made to the unitholder by Rio
Vista. Distributions by Rio Vista to a unitholder are generally not taxable
unless the amount of cash distributed is in excess of the unitholder's
adjusted basis in Rio Vista.
Section 7704 of the Internal Revenue Code (Code) provides that publicly
traded partnerships shall, as a general rule, be taxed as corporations
despite the fact that they are not classified as corporations under Section
7701 of the Code. Section 7704 of the Code provides an exception to this
general rule for a publicly traded partnership if 90% or more of its gross
income for every taxable year consists of "qualifying income" (Qualifying
Income Exception). For purposes of this exception, "qualifying income"
includes income and gains derived from the exploration, development, mining
or production, processing, refining, transportation (including pipelines)
or marketing of any mineral or natural resource. Other types of "qualifying
income" include interest (other than from a financial business or interest
based on profits of the borrower), dividends, real property rents, gains
from the sale of real property, including real property held by one
considered to be a "dealer" in such property, and gains from the sale or
other disposition of capital assets held for the production of income that
otherwise constitutes "qualifying income".
No ruling has been or will be sought from the IRS and the IRS has made no
determination as to Rio Vista's classification as a partnership for federal
income tax purposes or whether Rio Vista's operations generate a minimum of
90% of "qualifying income" under Section 7704 of the Code.
If Rio Vista were classified as a corporation in any taxable year, either
as a result of a failure to meet the Qualifying Income Exception or
otherwise, Rio Vista's items of income, gain, loss and deduction would be
reflected only on Rio Vista's tax return rather than being passed through
to Rio Vista's unitholders, and Rio Vista's net income would be taxed at
corporate rates.
If Rio Vista were treated as a corporation for federal income tax purposes,
Rio Vista would pay tax on income at corporate rates, which is currently a
maximum of 35%. Distributions to unitholders would generally be taxed again
as corporate distributions, and no income, gains, losses, or deductions
would flow through to the unitholders. Because a tax would be imposed upon
Rio Vista as a corporation, the cash available for distribution to
unitholders would be substantially reduced and Rio Vista's ability to make
minimum quarterly distributions would be impaired. Consequently, treatment
of Rio Vista as a corporation would result in a material reduction in the
anticipated cash flow and after-tax return to unitholders and therefore
would likely result in a substantial reduction in the value of Rio Vista's
common units.
Current law may change so as to cause Rio Vista to be taxable as a
corporation for federal income tax purposes or otherwise subject Rio Vista
to entity-level taxation. The Agreement provides that, if a law is enacted
or existing law is modified or interpreted in a manner that subject Rio
Vista to taxation as a corporation or otherwise subjects Rio Vista to
entity-level taxation for federal, state or local income tax purposes, then
the minimum quarterly distribution amount and the target distribution
amount will be adjusted to reflect the impact of that law on Rio Vista.
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to credit risk
include cash balances at banks which at times exceed the federal deposit
insurance.
18
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE J - CONTRACTS
LPG SALES TO PMI
For the months of October 2004 through December 2004, the Company and PMI
entered into monthly agreements for the minimum sale of 11,050,000 gallons
of LPG (Monthly 2004 Contracts). Prior to the Spin-Off, during the period
April 1, 2004 through September 30, 2004, the Company entered into monthly
agreements for the minimum sale of 11,050,000 gallons - 13,000,000 gallons
of LPG. Prior to April 1, 2004, the Company and PMI had operated under a
contract which provided for minimum monthly volumes of 17,000,000 gallons.
PMI has primarily used the Matamoros Terminal Facility to load LPG
purchased from the Company for distribution by truck in Mexico. The Company
continues to use the Brownsville Terminal Facility in connection with LPG
delivered by railcar to other customers, storage and as an alternative
terminal in the event the Matamoros Terminal Facility cannot be used.
LPG SUPPLY AGREEMENTS
The Company's current long-term supply agreements in effect as of October
31, 2004 (Supply Contracts) require the Company to purchase minimum
quantities of LPG totaling up to approximately 22,100,000 gallons per month
although the Monthly 2004 Contracts require PMI to purchase lesser
quantities. The actual amounts supplied under the Supply Contracts averaged
approximately 16,700,000 gallons per month for the three months ended
October 31, 2004.
In addition to the LPG costs charged by the Suppliers, the Company also
incurs additional costs to deliver LPG to the Company's facilities.
Furthermore, the Company may incur significant additional costs associated
with the storage, disposal and/or changes in LPG prices resulting from the
excess of LPG purchased under the Supply Contracts over actual sales
volumes to PMI. Under the terms of the Supply Contracts, the Company must
provide letters of credit in amounts equal to the cost of the product to be
purchased. In addition, the cost of the product purchased is tied directly
to overall market conditions. As a result, the Company's existing letter of
credit facility may not be adequate to meet the letter of credit
requirements under the agreements with the Suppliers or other suppliers due
to increases in quantities of LPG purchased and/or to finance future price
increases of LPG.
19
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE K - REALIZATION OF ASSETS
The accompanying consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United
States of America, which contemplate continuation of the Company as a going
concern. The Company has had an accumulated deficit since inception and has
historically had a deficit in working capital. In addition, substantially
all of the Company's assets are pledged or committed to be pledged as
collateral on existing debt in connection with the Restructured Notes, the
$280,000 Notes and the RZB Credit Facility and therefore, the Company maybe
unable to obtain additional financing collateralized by those assets. The
RZB Credit Facility may be insufficient to finance the Company's LPG sales
and/or Fuel Products sales, assuming increases in product costs per gallon,
or volumetric growth in product sales, and maybe terminated by RZB with 90
days notice.
Since April 1, 2004, the Company has been operating under the Monthly 2004
Contracts with PMI (see note J). The monthly volumes of LPG sold to PMI
since April 1, 2004 have been materially less than historical levels. As
discussed in note J, the Company has LPG supply contracts which require it
to purchase volumes of LPG materially in excess of monthly volumes under
the Monthly 2004 Contracts (Mismatched LPG). The volume of the Mismatched
LPG was materially lower prior to April 1, 2004 than subsequent to April 1,
2004, and the Company was able to dispose of the Mismatched LPG prior to
April 1, 2004 at acceptable margins. The Company may incur additional
reductions of gross profits on sales of LPG in disposing of the Mismatched
LPG if (i) the volume of LPG sold under the Monthly 2004 Contracts declines
below the current levels of approximately 11,000,000 gallons per month
and/or the margins are materially reduced and/or (ii) the Company cannot
successfully reduce the minimum volumes and/or purchase costs required
under the LPG supply agreements. The Company may not have sufficient cash
flow or available credit to absorb such reductions in gross profit.
The Company's cash flow has been reduced as a result of lower volumes of
sales to PMI. Additionally, the Company will also incur the additional
public company compliance and income tax preparation costs for Rio Vista.
As a result, the Company may not have sufficient cash flow to make
distributions to Rio Vista's unitholders and to pay Penn Octane's
obligations when due. In the event Penn Octane does not pay its obligations
when due, Rio Vista's guarantees to Penn Octane and Penn Octane's creditors
may be triggered. Accordingly, Rio Vista may be required to pay such
obligations of Penn Octane to avoid foreclosure of its assets by Penn
Octane's creditors. If the Company's revenues and other sources of
liquidity are not adequate to pay Penn Octane's obligations, Rio Vista may
be required to reduce or eliminate the quarterly distributions to
unitholders and Penn Octane or Rio Vista may be required to raise
additional funds to avoid foreclosure. There can be no assurance that such
additional funding will be available on terms attractive to either Penn
Octane or Rio Vista or available at all.
In view of the matters described in the preceding paragraphs,
recoverability of the recorded asset amounts shown in the accompanying
consolidated balance sheet is dependent upon the ability of the Company to
generate sufficient cash flow through operations or additional debt or
equity financing to pay its liabilities and obligations when due. The
ability for the Company to generate sufficient cash flows is significantly
dependent on the continued sale of LPG to PMI at acceptable monthly sales
volumes and margins, the success of the Fuel Sales Business and the
adequacy of the RZB Credit Facility to finance such sales. The consolidated
financial statements do not include any adjustments related to the
recoverability and classification of recorded asset amounts or amounts and
classification of liabilities that might be necessary should the Company be
unable to continue in existence.
20
PENN OCTANE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE K - REALIZATION OF ASSETS - CONTINUED
To provide the Company with the ability it believes necessary to continue
in existence, management is negotiating with PMI to increase LPG sales at
acceptable monthly volumes and margins. In addition, management is taking
steps to (i) expand its Fuel Sales Business, (ii) further diversify its
operations to reduce dependency on sales of LPG, (iii) increase the amount
of financing for its products and operations, and (iv) raise additional
debt and/or equity capital.
21
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
PENN OCTANE CORPORATION AND ITS CONSOLIDATED SUBSIDIARIES WHICH INCLUDES
RIO VISTA ENERGY PARTNERS L.P. AND ITS SUBSIDIARIES ARE HEREINAFTER REFERRED TO
AS THE "COMPANY".
The following discussion of the Company's results of operations and
liquidity and capital resources should be read in conjunction with the
consolidated financial statements of the Company and related notes thereto
appearing elsewhere herein. References to specific years preceded by "fiscal"
(e.g. fiscal 2004) refer to the Company's fiscal year ended July 31.
FORWARD-LOOKING STATEMENTS
The statements contained in this Quarterly Report that are not historical facts
are forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
These forward-looking statements may be identified by the use of forward-looking
terms such as "believes," "expects," "may," "will", "should" or "anticipates" or
by discussions of strategy that inherently involve risks and uncertainties. From
time to time, the Company has made or may make forward-looking statements,
orally or in writing. These forward-looking statements include statements
regarding anticipated future revenues, sales, LPG supply, operations, demand,
competition, capital expenditures, the deregulation of the LPG market in Mexico,
the operations of the US - Mexico Pipelines, the Matamoros Terminal Facility,
the remaining Saltillo Terminal assets, other upgrades to facilities, foreign
ownership of LPG operations, short-term obligations and credit arrangements,
Fuel Sales Business, the Spin-Off, cash distributions, "Qualified Income" and
other statements regarding matters that are not historical facts, and involve
predictions which are based upon a number of future conditions that ultimately
may prove to be inaccurate. Actual results, performance or achievements could
differ materially from the results expressed in, or implied by, these
forward-looking statements. Factors that may cause or contribute to such
differences include those discussed under "Risk Factors" and "Management's
Discussion and Analysis of Financial Condition and Results of Operations," as
well as those discussed elsewhere in this Report. We caution you, however, that
the following list of factors may not include all material risks facing the
Company.
RISK FACTORS
Business Factors. The expiration of the LPG sales contract with PMI and
the resulting lower LPG sales volumes may adversely affect the Company's results
of operations. The Company has only one customer for LPG, Rio Vista, and Rio
Vista has only one customer for LPG in Mexico, PMI. The Company just recently
commenced its Fuel Sales Business. The Company cannot be sure that PMI will
continue to purchase LPG from Rio Vista or in quantities or prices that are
profitable. There are a limited number of suppliers of LPG that connect to Rio
Vista's pipelines and a limited supply of LPG. The Company may lose its
competitive advantage when the Company's Seadrift pipeline lease expires in
2013. The Company may be unable to successfully develop additional sources of
revenue in order to reduce its dependence on Rio Vista. The Company may not
have sufficient cash to meet its obligations. All of the Company's assets are
pledged as collateral for existing debt, and the Company therefore may be unable
to obtain additional financing collateralized by such assets. The Company is at
risk of economic loss due to fixed margin contracts. If the Company does not
have sufficient capital resources for acquisitions or opportunities for
expansion, the Company's growth will be limited. The Company's ability to grow
the Fuel Sales Business is largely dependent on available financing which may be
limited. Future acquisitions and expansions may not be successful, may
substantially increase the Company's indebtedness and contingent liabilities,
and may create integration difficulties. The Company's business would be
adversely affected if operations at Rio Vista's transportation, terminal and
distribution facilities were interrupted. The Company's business would also be
adversely affected if the operations of the Company's or Rio Vista's customers
and suppliers were interrupted.
Competitive Factors. The energy industry is highly competitive. There is
competition within the industries and also with other industries in supplying
the energy and fuel needs of the industry and individual consumers. The Company
competes with other firms in the sale or purchase of LPG and Fuel Products as
well as the transportation of these products in the US and Mexican markets and
employs all methods of competition which are lawful and appropriate for such
purposes. A key component of the Company's competitive position, particularly
given the commodity-based nature of many of its products, is its ability to
manage its expenses successfully, which requires continuous management focus on
reducing unit costs and improving efficiency and its ability to secure unique
opportunities for the purchase, sale and/or delivery methods of its products.
22
International Factors. Mexican economic, political and social conditions
may change and adversely affect Rio Vista's operations. Rio Vista may not be
able to continue operations in Mexico if Mexico restricts the existing ownership
structure of its Mexican operations, requiring Rio Vista to increase its
reliance on Mexican nationals to conduct its business. The LPG market in Mexico
is undergoing deregulation, the results of which may hinder Rio Vista's ability
to negotiate acceptable contracts with distributors. Rio Vista's contracts and
Mexican business operations are subject to volatility in currency exchange rates
which could negatively impact its earnings.
Political Factors. The operations and earnings of the Company and its
consolidated affiliate in the US and Mexico have been, and may in the future be,
affected from time to time in varying degree by political instability and by
other political developments and laws and regulations, such as forced
divestiture of assets; restrictions on production, imports and exports; war or
other international conflicts; civil unrest and local security concerns that
threaten the safe operation of the Company's facilities; price controls; tax
increases and retroactive tax claims; expropriation of property; cancellation of
contract rights; and environmental regulations. Both the likelihood of such
occurrences and their overall effect upon the Company vary greatly and are not
predictable.
Industry and Economic Factors. The operations and earnings of the Company
and its consolidated affiliate throughout the US and Mexico are affected by
local, regional and global events or conditions that affect supply and demand
for the Company's products. These events or conditions are generally not
predictable and include, among other things, general economic growth rates and
the occurrence of economic recessions; the development of new supply sources for
its products; supply disruptions; weather, including seasonal patterns that
affect energy demand and severe weather events that can disrupt operations;
technological advances, including advances in exploration, production, refining
and advances in technology relating to energy usage; changes in demographics,
including population growth rates and consumer preferences; and the
competitiveness of alternative hydrocarbon or other energy sources or product
substitutes.
Project Acquisition Factors. In additional to the factors cited above, the
advancement, cost and results of particular projects sought by the Company,
including projects which do not specifically fall within the areas of the
Company's current lines of businesses will depend on the outcome of negotiations
for such acquisitions; the ability of the Company's management to manage such
businesses; the ability of the Company to obtain financing for such
acquisitions; changes in operating conditions or costs; and the occurrence of
unforeseen technical difficulties.
Market Risk Factors. See "Notes to Consolidated Financial Statements
(Unaudited)," "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Quantitative and Qualitative Disclosures About
Market Risk" in this report for discussion of the impact of market risks,
inflation and other uncertainties.
Projections, estimates and descriptions of the Company's plans and
objectives included or incorporated in "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and elsewhere in this report are
forward-looking statements. Actual future results could differ materially due
to, among other things, the factors discussed above and elsewhere in this
report.
OVERVIEW
The Company has been principally engaged in the purchase, transportation
and sale of LPG for distribution into northeast Mexico. In connection with the
Company's desire to reduce quantities of inventory, the Company also sells LPG
to U.S. and Canadian customers.
During the three months ended October 31, 2004, the Company derived 75% of
its LPG revenues and 51% of total revenues from sales of LPG to PMI, its primary
customer.
The Company provides products and services through a combination of
fixed-margin and fixed-price contracts. Costs included in cost of goods sold,
other than the purchase price of LPG, may affect actual profits from sales,
including costs relating to transportation, storage, leases and maintenance.
Mismatches in volumes of LPG purchased from suppliers and volumes sold to PMI or
others could result in gains during periods of rising LPG prices or losses
during periods of declining LPG prices as a result of holding inventories or
disposing of excess inventories.
23
During June 2004, the Company began the Fuel Sales Business with the
ability to access certain pipeline and terminal systems located in California,
Arizona, Nevada and Texas. Fuel Sales approximated $21.6 million for the three
months ended October 31, 2004 which represents approximately 33% of total
revenues.
On September 30, 2004, Penn Octane completed a series of transactions
involving (i) the transfer of substantially all of its owned pipeline and
terminal assets in Brownsville and Matamoros to RVOP (ii) transferred its 99.9%
interest in RVOP to Rio Vista and (iii) the Spin-Off, resulting in Rio Vista
becoming a separate public company. The Common Units represented 98% of Rio
Vista's outstanding units. The remaining 2% of such units, which is the general
partner interest, is owned and controlled by the General Partner, and the
General Partner will is responsible for the management of Rio Vista.
Accordingly the Company has control of Rio Vista by virtue of its ownership and
related voting control of the General Partner and therefore, Rio Vista is
consolidated with the Company and the interests of the limited partners are
classified as minority interests in the Company's consolidated financial
statements. Subsequent to the Spin-Off, Rio Vista sells LPG directly to PMI and
purchases LPG from Penn Octane under a long-term supply agreement. The purchase
price of the LPG from Penn Octane is determined based on the cost of LPG under
Penn Octane's LPG supply agreements with its suppliers, other direct costs
related to PMI sales and a formula that takes into consideration operating costs
of Penn Octane and Rio Vista.
Penn Octane continues to sell LPG to PMI through its supply contract with
Rio Vista, and it shifted certain costs of operations related to the Brownsville
and Matamoros terminals and pipelines, and certain administrative costs to Rio
Vista. In addition, it continues to manage Rio Vista through the General
Partner and to explore opportunities to acquire and grow other lines of business
such as the Fuel Sales Business described below. Penn Octane will benefit from
the Spin-Off indirectly based on the success of Rio Vista through Penn Octane's
ownership of the General Partner. As a limited partnership, Rio Vista is
expected to have the following benefits not available to Penn Octane.
- Tax Efficiency. As a limited partnership, Rio Vista is expected to be
able to operate in a more tax efficient manner by eliminating
corporate federal income taxes on a portion of future taxable income
which would have been fully subject to corporate federal income taxes.
- Raising Capital. As a limited partnership, Rio Vista is expected to
have an improved ability to raise capital for expansion.
- Acquisitions. Due to industry preference and familiarity with the
limited partnership structure, Rio Vista is expected to have a
competitive advantage over a company taxed as a corporation in making
acquisitions of assets that generate "qualifying income," as this term
is defined in Section 7704 of the Internal Revenue Code.
- Recognition. As a limited partnership, Penn Octane anticipates that
both Penn Octane and Rio Vista will receive increased analyst coverage
and acceptance in the marketplace.
LPG SALES
The following table shows the Company's volume sold and delivered in
gallons and average sales price for the three months ended October 31, 2004 and
2003;
2004 2003
----- -----
Volume Sold
LPG (millions of gallons) - PMI 35.1 48.6
LPG (millions of gallons) - Other 13.0 14.3
----- -----
48.1 62.9
===== =====
Average sales price
LPG (per gallon) - PMI $0.94 $0.64
LPG (per gallon) - Other 0.83 0.53
24
RECENT TRENDS. Since April 2004, PMI has contracted with the Company for
volumes which are significantly lower than amounts purchased by PMI in similar
periods during previous years. See Liquidity and Capital Resources - Sales to
PMI below. The Company believes that the reduction of volume commitments is
based on additional LPG production by PEMEX being generated from the Burgos
Basin field in Reynosa, Mexico, an area within the proximity of the Company's
Mexican terminal facilities. Although the Company is not aware of the total
amount of LPG actually being produced by PEMEX from the Burgos Basin, it is
aware that PEMEX has constructed and is operating two new cryogenic facilities
at the Burgos Basin which it believes may have a capacity of producing up to 12
million gallons of LPG per month. The Company also believes that PEMEX is
intending to install two additional cryogenic facilities, with similar capacity,
to be operational in early 2006. The Company is also not aware of the capacity
at which the current cryogenic facilities are being operated. Furthermore, the
Company is not aware of the actual gas reserves of the Burgos Basin or the gas
quality, each of which could significantly impact LPG production amounts. The
Company still believes that its LPG supplies are competitive with the necessary
US imports of LPG by PEMEX and that the LPG volumes which are actually produced
from the Burgos Basin would not eliminate the need for US LPG imports by PEMEX
and that LPG volumes produced from the Burgos Basin would be more economically
suited for distribution to points further south in Mexico rather than in the
Company's strategic zone.
During June 2004, Valero L.P., a U.S. limited partnership ("Valero") began
operation of a newly constructed LPG terminal facility in Nuevo Laredo, Mexico
and a newly constructed pipeline connecting the terminal facility in Nuevo
Laredo, Mexico to existing pipelines in Juarez, Texas which connect directly to
Valero Energy Corporation's Corpus Christi, Texas and Three Rivers, Texas
refineries. Valero has contracted with PMI under a five year agreement to
deliver approximately 6.3 million gallons (of which 3.2 million gallons were
previously delivered by truck from Three Rivers, Texas) of LPG per month.
Valero has also indicated that it intends to increase capacity of its Nuevo
Laredo terminal to 10.1 million gallons per month. The Company believes that if
Valero intends to maximize capacity of these facilities, then it would be
required to obtain additional LPG supplies from major LPG hubs located in Corpus
Christi and Mont Belvieu, Texas. Accordingly, the Company believes that any
additional supplies over amounts currently available to the Mexican market
through Valero's system could be more expensive than the Company's currently
available supplies and delivery systems.
During 2004, a pipeline operated by El Paso Energy between Corpus Christi,
Texas and Hidalgo County, Texas was closed. Historically these facilities had
supplied approximately 5.0 million gallons of LPG per month to the Company's
strategic zone. The Company is not aware of any future plans for these
facilities.
During 2003, PMI constructed and began operations of a refined products
cross border pipeline connecting a pipeline running from PEMEX's Cadereyta
Refinery in Monterey, Mexico to terminal facilities operated by Transmontagne,
Inc., in Brownsville, Texas. Transmontagne is a U.S. corporation. The
pipeline crosses the US-Mexico border near the proximity of the Company's
pipelines. In connection with the construction of the pipeline, PMI was
required to obtain an easement from the Company for an approximate 21.67 acre
portion of the pipeline. Under the terms of the easement, PMI has warranted
that it will not transport LPG through October 15, 2017.
RESULTS OF OPERATIONS
THREE MONTHS ENDED OCTOBER 31, 2004 COMPARED WITH THREE MONTHS ENDED OCTOBER 31,
2003
Summary. The accompanying financial statements for the three months ended
October 31, 2004 reflect a net loss of $(235,080) [$(469,177) before loss
allocable to minority interest in Rio Vista] compared to a net loss for the
three months ended October 31, 2003 of $(158,516). Included in the net loss for
the quarter ended October 31, 2004 were nonrecurring expenses associated with
the Spin-Off of Rio Vista of approximately $550,000, non-cash stock based
compensation of approximately $385,000 and non-cash depreciation and
amortization of approximately $242,000. Included in net loss for the quarter
ended October 31, 2003 were approximately $425,000 of non-recurring expenses
associated with the Spin-Off of Rio Vista, a loss on the sale of CNG assets of
$500,000 and non-cash depreciation and amortization of approximately $222,000.
Revenues. Revenues for the three months ended October 31, 2004, were $65.5
million compared with $38.5 million for the three months ended October 31, 2003,
an increase of $27.0 million or 70.0%. Of this increase, $14.9 million was
attributable to increases in average sales prices of LPG sold to PMI during the
three months ended October 31, 2004, $4.3 million was attributable to increased
average sales prices of LPG sold to customers other than PMI during the three
months ended October 31, 2004 and $21.6 million was attributable to new revenues
generated from the Company's Fuel Sales Business which commenced during the
fiscal 2004, partially offset by $12.8 million attributable to decreased volumes
of LPG sold to PMI during the three months ended October 31, 2004 and $1.1
million attributable to decreased volumes of LPG sold to customers other than
PMI during the three months ended October 31, 2004.
25
Cost of goods sold. Cost of goods sold for the three months ended October
31, 2004 was $63.5 million compared with $36.5 million for the three months
ended October 31, 2003, an increase of $27.0 million or 74.1%. Of this
increase, $14.6 million was attributable to increases in the cost of LPG sold to
PMI during the three months ended October 31, 2004, $4.1 million was
attributable to increased costs of LPG sold to customers other than PMI during
the three months ended October 31, 2004 and $21.1 million was attributable to
new costs of goods sold arising from the Company's Fuel Sales Business which
commenced operations during fiscal 2004, partially offset by $1.2 million
attributable to decreased volume of LPG sold to customers other than PMI during
the three months ended October 31, 2004 and $11.6 million attributable to
decreased volume of LPG sold to PMI during the three months ended October 31,
2004.
Selling, general and administrative expenses. Selling, general and
administrative expenses were $2.0 million for the three months ended October 31,
2004, compared with $1.5 million for the three months ended October 31, 2003, an
increase of $487,026 or 31.6%. The increase during the three months ended
October 31, 2004, was principally due to increases in non-cash salary and
payroll related fees of $384,574 associated with the issuance of warrants and
options, alternative minimum tax and state franchise tax associated with the
Spin-Off of approximately $238,000 and other taxes associated with its Mexican
subsidiaries, partially offset by reduced professional fees associated with the
Spin-Off.
Loss on sale of CNG assets. During the three months ended October 31,
2003, the Company recorded a loss on the sale of CNG assets of $500,000.
Other income (expense). Other income (expense) was $(113,666) for the
three months ended October 31, 2004, compared with $(160,247) for the three
months ended October 31, 2003. The decrease in other expense was due primarily
to minority interest income of $234,097 during the three months ended October
31, 2004, partially offset by reduced income related to the cancellation of a
contract of $210,000 during the three months ended October 31, 2003.
Income tax. Due to the availability of net operating loss carryforwards
(approximately $4.7 million at July 31, 2004), the Company did not incur U.S.
income tax expense during the three months ended October 31, 2004. The taxable
income associated with the Spin-Off was included in the Company's October 31,
2004 calculation of U.S. income tax expense. However, the Company did incur
alternative minimum income tax expense of $86,396 during the three months ended
October 31, 2004. The Mexican subsidiaries file their income tax returns on a
calendar year basis. The Company can receive a credit against any future tax
payments due to the extent of any prior alternative minimum taxes paid.
LIQUIDITY AND CAPITAL RESOURCES
General. The Company has had an accumulated deficit since its inception
and has historically had a deficit in working capital. In addition,
substantially all of the Company's assets are pledged or committed to be pledged
as collateral on existing debt in connection with the Restructured Notes, the
$280,000 Notes and the RZB Credit Facility. The RZB Credit Facility is an
uncommitted facility which is authorized every ninety days and is reviewed
annually at March 31. The Company may need to increase its credit facility for
increases in quantities of LPG and Fuel Products purchased and/or to finance
future price increases of LPG and Fuel Products. The Company depends heavily on
sales to one major customer, PMI. Since April 1, 2004 the Company has been
operating on month-to-month contracts with PMI (see below). The Company's
sources of liquidity and capital resources historically have been provided by
sales of LPG, proceeds from the issuance of short-term and long-term debt,
revolving credit facilities and credit arrangements, sale or issuance of
preferred and common stock of the Company and proceeds from the exercise of
warrants to purchase shares of the Company's common stock.
Penn Octane has recently completed the transfer of a major portion of its
assets to Rio Vista and the Spin-Off of Rio Vista to its stockholders. As a
result of the Spin-Off, the Company's stockholders' equity has been materially
reduced by the amount of the Spin-Off and a portion of Penn Octane's current
cash flow from operations has shifted to Rio Vista as of the date of the
Spin-Off. Therefore, Penn Octane's remaining cash flow may not be sufficient
to allow Penn Octane to pay its liabilities and obligations when due. Rio Vista
is liable as guarantor on Penn Octane's collateralized debt discussed in the
preceding paragraph and continues to pledge all of its assets as collateral.
Penn Octane does not believe that it has a federal income tax in connection with
the Spin-Off due to utilization of existing net operating loss carryforwards.
The Company estimates alternative minimum tax and state franchise tax of
approximately $238,000. However, the Internal Revenue Service (the "IRS") may
review Penn Octane's federal income tax returns and challenge positions that
Penn Octane may take when preparing those income tax returns, including
positions that it may take with respect to the Spin-Off. If the IRS challenges
26
any of the Company's positions, Penn Octane will vigorously defend the positions
that it takes in preparing its federal income tax, including positions that it
may take with respect to the Spin-Off. In addition, Rio Vista has agreed to
indemnify Penn Octane for a period of three years from the fiscal year end that
includes the date of the Spin-Off for any federal income tax liabilities
resulting from the Spin-Off in excess of $2.5 million (see Spin-Off below).
The volume of LPG sold to PMI has been materially reduced over historical
levels resulting in a reduction of the Company's cash flow (see discussion
below). In addition, Rio Vista intends to make distributions on a quarterly
basis to its unitholders beginning in February 2005. Initially, those
distributions are expected to be approximately $500,000 per quarter. Also,
during the three months ended October 31, 2004, professional fees and related
costs associated with the Spin-Off totaled approximately $545,788. The Company
expects to eliminate these costs in future periods. However, as a result of the
Spin-Off, the Company estimates that consolidated operating expenses will
increase by approximately $450,000 on an annual basis as a result of additional
public company compliance and income tax preparation costs related to Rio Vista.
As a result of the reduced cash flow and the intention of Rio Vista to make
distributions, there may not be sufficient cash flow to make such
distributions and to pay Penn Octane's obligations when due. In the event Penn
Octane is unable to pay its liabilities and obligations when due, Rio Vista's
payment obligations may be triggered under its guarantees to Penn Octane and
Penn Octane's creditors and Rio Vista may be required to pay such liabilities
and obligations of Penn Octane to avoid foreclosure of its assets by Penn
Octane's creditors. Although Rio Vista is not required to do so, if Penn Octane
is unable to pay its obligations when they become due, Rio Vista may lend the
necessary funds to Penn Octane. Conversely, if Rio Vista does not have the
funds necessary to make its distributions, to the extent that Penn Octane has
sufficient cash to do so, it intends to lend such amounts to Rio Vista. If Rio
Vista's revenues and other sources of liquidity after its quarterly
distributions are not adequate to satisfy such payment obligations of Penn
Octane and/or Penn Octane does not have the necessary cash to loan to Rio Vista,
Rio Vista may be required to reduce or eliminate the quarterly distributions to
unitholders and Penn Octane or Rio Vista may be required to raise additional
funds to avoid foreclosure. However, there can be no assurance that such
additional funding will be available on terms attractive to either Penn Octane
or Rio Vista or available at all.
In the event Penn Octane is required to raise additional funds, management
does not believe that it would be able to obtain such financing from traditional
commercial lenders. Rather, Penn Octane would likely have to conduct sales of
its equity and/or debt securities through public or private financings,
collaborative relationships or other arrangements.
If additional amounts cannot be raised and Penn Octane is unable to
restructure its obligations, material adverse consequences to its business,
financial condition, results of operations would likely occur. Further, if Penn
Octane is determined to have a federal income tax liability as a result of the
Spin-Off and if Penn Octane is unable to pay such liabilities, the Internal
Revenue Service may assert that the Penn Octane stockholders who receive common
units in the Spin-Off are liable for unpaid federal income taxes of Penn Octane,
including interest and any penalties, up to the value of the Rio Vista Common
Units received by each stockholder.
The following summary table reflects comparative cash flows for three
months ended October 31, 2004, and 2003. All information is in thousands.
2004 2003
------------ ------------
Net cash used in operating activities . . . . . . . $( 1,235) $( 559)
Net cash provided by (used in) investing activities 1 ( 92)
Net cash provided by financing activities . . . . . 1,361 672
------------ ------------
Net increase in cash. . . . . . . . . . . . . . . . $ 127 $ 21
============ ============
27
Sales to PMI. On March 31, 2004, the Company's sales agreement with PMI
("Contract") expired. During the months of April 2004 through December 2004,
the Company and PMI have entered into monthly agreements for the sale of LPG
(the "Monthly 2004 Contracts"). Under the terms of the Monthly 2004 Contracts
for April, May and June, the minimum amount of LPG to be purchased per month by
PMI was 13.0 million gallons. Under the terms of the Monthly 2004 Contracts for
July, August and September, the minimum amount of LPG to be purchased per month
by PMI was 11.7 million gallons. Under the terms of the Monthly 2004 Contracts
for October, November and December, the minimum amount of LPG to be purchased
per month by PMI is 11.1 million gallons. During the months of April 2004, May
2004, June 2004, July 2004, August 2004, September 2004, October 2004 and
November 2004, the actual amount of LPG purchased by PMI was approximately 13.1
million gallons, 13.4 million gallons, 13.8 million gallons, 12.3 million
gallons, 12.4 million gallons, 11.8 million gallons, 10.9 million gallons and
12.4 million gallons, respectively. The expiration of the Contract has caused a
reduction in the Company's gross revenue due to the reduction in LPG volumes
sold to PMI from approximately 17 million gallons per month under the Contract
to approximately 11 million gallons per month under the Monthly 2004 Contracts.
The Company continues to negotiate for the extension and/or renewal of the
LPG contract with PMI. There is no assurance that the LPG contract with PMI
will be extended and/or renewed, and if so, that the terms will be more or less
favorable than those of the Monthly 2004 Contracts. Until the terms of a new
long-term contract are reached, the Company expects to enter into additional
monthly agreements similar to the Monthly 2004 Contracts.
The Company's management believes that PMI's reduction of volume
commitments for April 2004 through November 2004 is based on additional LPG
production by PEMEX being generated from the Burgos Basin field in Reynosa,
Mexico, an area within the proximity of the Company's Mexican terminal
facilities. In the event the volume of LPG purchased by PMI under the
month-to-month agreements declines below the current level of approximately 11
million gallons, assuming margins remain unchanged, the Company could suffer
material adverse consequences to its business, financial condition and results
of operations to the extent that the Company is unable to obtain additional
favorable price and/or volume concessions from LPG suppliers. The Company is
attempting to obtain additional price and/or volume concessions from its LPG
suppliers to lower costs. If the Company is unsuccessful in lowering its costs
to offset a decline in volumes below 11 million gallons per month and/or the
Company is forced to accept similar or lower prices for sales to PMI, the
results of operations of the Company may be adversely affected. The Company
may not have sufficient cash flow or available credit to absorb such reductions
in gross profit.
PMI has primarily used the Matamoros Terminal Facility to load LPG
purchased from the Company for distribution by truck in Mexico. The Company
continues to use the Brownsville Terminal Facility in connection with LPG
delivered by railcar to other customers, storage and as an alternative terminal
in the event the Matamoros Terminal Facility cannot be used.
Revenues from PMI totaled approximately $33.1 million and $30.9 million for
the three months ended October 31, 2004 and 2003, respectively, representing
approximately 50.5% and 80.2% of total revenues for the periods and 75.4% and
80.2% of the Company's total LPG revenues for the periods.
Seasonality. The Company's gross profit is dependent on sales volume of
LPG to PMI, which fluctuates in part based on the seasons. The demand for LPG
is strongest during the winter season.
LPG Supply Agreements. Effective October 1, 1999, the Company and Exxon
entered into a ten year LPG supply contract, as amended (the "Exxon Supply
Contract"), whereby Exxon has agreed to supply and the Company has agreed to
take, 100% of Exxon's owned or controlled volume of propane and butane available
at Exxon's King Ranch Gas Plant (the "Plant") up to 13.9 million gallons per
month blended in accordance with required specifications (the "Plant
Commitment"). For the three months ended October 31, 2004, under the Exxon
Supply Contract, Exxon has supplied an average of approximately 11.0 million
gallons of LPG per month. The purchase price is indexed to variable posted
prices.
28
In addition, under the terms of the Exxon Supply Contract, Exxon made its
Corpus Christi Pipeline (the "ECCPL") operational in September 2000. The
ability to utilize the ECCPL allows the Company to acquire an additional supply
of propane from other propane suppliers located near Corpus Christi, Texas (the
"Additional Propane Supply"), and bring the Additional Propane Supply to the
Plant (the "ECCPL Supply") for blending to the required specifications and then
delivered into the Leased Pipeline. The Company agreed to flow a minimum of
122.0 million gallons per year of Additional Propane Supply through the ECCPL
until December 2005. The Company is required to pay minimum utilization fees
associated with the use of the ECCPL until December 2005. Thereafter the
utilization fees will be based on the actual utilization of the ECCPL.
In March 2000, the Company and Koch Hydrocarbon Company ("Koch") entered
into a three year supply agreement (the "Koch Supply Contract") whereby Koch has
agreed to supply and the Company has agreed to take, a monthly average of 8.2
million gallons (the "Koch Supply") of propane beginning April 1, 2000, subject
to the actual amounts of propane purchased by Koch from the refinery owned by
its affiliate, Koch Petroleum Group, L.P. In March 2003 the Company extended
the Koch Supply Contract for an additional year pursuant to the Koch Supply
Contract which provides for automatic annual renewals unless terminated in
writing by either party. During December 2003, the Company and Koch entered
into a new three year supply agreement. The terms of the new agreement are
similar to the agreement previously in effect between the parties.
For the three months ended October 31, 2004, under the Koch Supply
Contract, Koch has supplied an average of approximately 5.7 million gallons of
propane per month. The purchase price is indexed to variable posted prices.
The Company is currently purchasing LPG from the above-mentioned suppliers
(the "Suppliers"). The Company's aggregate costs per gallon to purchase LPG
(less any applicable adjustments) are below the aggregate sales prices per
gallon of LPG sold to its customers.
The Company's current long-term supply agreements in effect as of October
31, 2004 ("Supply Contracts") require the Company to purchase minimum quantities
of LPG totaling up to approximately 22.1 million gallons per month although the
Monthly 2004 Contracts require PMI to purchase lesser quantities. The actual
amounts supplied under Supply Contracts averaged approximately 16.7 million
gallons per month for the three months ended October 31, 2004.
In addition to the LPG costs charged by the Suppliers, the Company also
incurs additional costs to deliver the LPG to the Company's facilities.
Furthermore, the Company may incur significant additional costs associated with
the storage, disposal and/or changes in LPG prices resulting from the excess LPG
purchased under the Supply Contracts over actual sales volumes to PMI. Under
the terms of the Supply Contracts, the Company must provide letters of credit in
amounts equal to the cost of the product to be purchased. In addition, the cost
of the product purchased is tied directly to overall market conditions. As a
result, the Company's existing letter of credit facility may not be adequate to
meet the letter of credit requirements under the agreements with the Suppliers
or other suppliers due to increases in quantities of LPG purchased and/or to
finance future price increases of LPG.
Credit Arrangements. As of October 31, 2004, Penn Octane had a $15.0
million credit facility (increased to $20.0 million on November 12, 2004) with
RZB Finance LLC ("RZB") for demand loans and standby letters of credit (the "RZB
Credit Facility") to finance Penn Octane's purchases of LPG and Fuel Products in
connection with Penn Octane's Fuel Sales Business. The RZB Credit facility is an
uncommitted facility under which the letters of credit have an expiration date
of no more than 90 days and the facility reviewed annually at March 31. In
connection with the RZB Credit Facility, the Company granted RZB a security
interest and assignment in any and all of the Company's accounts, inventory,
real property, buildings, pipelines, fixtures and interests therein or relating
thereto, including, without limitation, the lease with the Brownsville
Navigation District of Cameron County (the "District") for the land on which the
Company's Brownsville Terminal Facility is located, the Pipeline Lease, and in
connection therewith agreed to enter into leasehold deeds of trust, security
agreements, financing statements and assignments of rent. Under the RZB Credit
Facility, the Company may not permit to exist any subsequent lien, security
interest, mortgage, charge or other encumbrance of any nature on any of its
properties or assets, except in favor of RZB, without the consent of RZB. After
the Spin-Off and transfer of assets to Rio Vista, RZB continues to retain a
security interest in the transferred assets.
29
Under the RZB Credit Facility, the Company pays a fee with respect to each
letter of credit thereunder in an amount equal to the greater of (i) $500, (ii)
2.5% of the maximum face amount of such letter of credit, or (iii) such higher
amount as may be agreed to between the Company and RZB. Any loan amounts
outstanding under the RZB Credit Facility shall accrue interest at a rate equal
to the rate announced by the JPMorgan Chase Bank as its prime rate (4.75% at
October 31, 2004) plus 2.5%. Pursuant to the RZB Credit Facility, RZB has sole
and absolute discretion to limit or terminate its participation in the RZB
Credit Facility and to refrain from making any loans or issuing any letters of
credit thereunder. RZB also has the right to demand payment of any and all
amounts outstanding under the RZB Credit Facility at any time. In addition to
the fees described above, the Company is required to pay RZB annual fees of
$50,000.
Based on current minimum purchase commitments under the Company's LPG
supply agreements and current LPG prices, the amount available to finance Fuel
Products and LPG purchases in excess of current minimum purchase commitments is
limited to current volumes and therefore the ability of the Company to grow the
Fuel Sales Business is dependent on future increases in its RZB Credit Facility
or other sources of financing, the reduction of LPG supply commitments and/or
the reduction in LPG or Fuel Products prices.
Under the terms of the RZB Credit Facility, either Penn Octane or Rio Vista
is required to maintain net worth of a minimum of $9.0 million ($10.0 million
effective November 12, 2004).
Mr. Richter has personally guaranteed all of Penn Octane's payment
obligations with respect to the RZB Credit Facility.
In connection with the Company's purchases of LPG and Fuel Products,
letters of credit are issued based on anticipated purchases. Outstanding
letters of credit for purchases of LPG and Fuel Products at October 31, 2004
totaled approximately $16.3 million which represents October 2004 purchases.
In connection with the Company's purchase of LPG and Fuel Products, under
the RZB Credit Facility, assets related to product sales (the "Assets") are
required to be in excess of borrowings and commitments (including restricted
cash of approximately $2.5 million at October 31, 2004). At October 31, 2004,
the Company's borrowings and commitments were less than the amount of the
Assets.
In connection with the Company's Fuel Sales Business, the Company has
issued bonds totaling $662,000 to the states of California, Nevada, Arizona and
Texas (the "Bonds") to secure payments of excise and other taxes collected from
customers in connection with sales of Fuel Products. The Bonds are partially
secured by letters of credit totaling $452,600. At October 31, 2004, such taxes
of approximately $542,000 were due. In addition, in connection with the Fuel
Sales Business, the Company issued a letter of credit of $284,000 in connection
with the Company's use of pipeline and terminal systems from a third party. The
letters of credit issued have all been secured by cash in the amount of $736,600
which is included in restricted cash in the Company's balance sheet at October
31, 2004.
LPG and Fuel Products financing expense associated with the RZB Credit
Facility totaled $213,862, and $188,469 for the three months ended October 31,
2004 and 2003.
30
The following is a summary of the Company's estimated minimum contractual
obligations and commercial obligations as of October 31, 2004. Where
applicable, LPG prices are based on the October 31, 2004 monthly average as
published by Oil Price Information Services.
PAYMENTS DUE BY PERIOD
(AMOUNTS IN MILLIONS)
---------------------------------------------------
Less than 1 - 3 4 - 5 After
Contractual Obligations Total 1 Year Years Years 5 Years
----------------------- ------ ---------- --------- ---------- --------
Long-Term Debt Obligations $ 1.7 $ - $ 1.7 $ - $ -
Operating Leases 11.1 1.4 2.7 2.6 4.4
LPG Purchase Obligations 835.6 211.9 353.3 270.4 -
Other Long-Term Obligations .1 - .1 - -
------ ---------- --------- ---------- --------
Total Contractual Cash Obligations $848.5 $ 213.3 $ 357.8 $ 273.0 $ 4.4
====== ========== ========= ========== ========
AMOUNT OF COMMITMENT EXPIRATION
PER PERIOD
(AMOUNTS IN MILLIONS)
---------------------------------------------------------
Commercial Total Amounts Less than 1 - 3 4 - 5 Over
Commitments Committed 1 Year Years Years 5 Years
----------- -------------- ---------- ------- ---------- --------
Lines of Credit $ 1.0 $ 1.0 $ - $ - $ -
Standby Letters of Credit 16.3 16.3 - - -
Guarantees N/A N/A N/A N/A N/A
Standby Repurchase Obligations N/A N/A N/A N/A N/A
Other Commercial Commitments N/A N/A N/A N/A N/A
-------------- ---------- ------- ---------- --------
Total Commercial Commitments $ 17.3 $ 17.3 $ - $ - $ -
============== ========== ======= ========== ========
Distributions of Available Cash. All unitholders, including the General
Partner, have the right to receive distributions of "available cash" as defined
in the partnership agreement ("Agreement") from Rio Vista in an amount equal to
the minimum distribution of $0.25 per quarter per unit, plus any arrearages in
the payment of the minimum quarterly distribution on the units from prior
quarters. The distributions are to be paid 45 days after the end of each
calendar quarter. However, Rio Vista is prohibited from making any distributions
to unitholders if it would cause an event of default, or an event of default is
existing, under any obligation of Penn Octane which Rio Vista has guaranteed.
Cash distributions from Rio Vista will be shared by the holders of the
common units and the General Partner Units as described in the Agreement based
on a formula whereby the General Partner will receive disproportionately more
distributions per unit than the holders of the common units as annual cash
distributions exceed certain milestones.
Partnership Tax Treatment. Rio Vista is not a taxable entity (see
below) and incurs no federal income tax liability. Instead, each unitholder of
Rio Vista is required to take into account that unitholder's share of items of
income, gain, loss and deduction of Rio Vista in computing that unitholder's
federal income tax liability, even if no cash distributions are made to the
unitholder by Rio Vista. Distributions by Rio Vista to a unitholder are
generally not taxable unless the amount of cash distributed is in excess of the
unitholder's adjusted basis in Rio Vista.
31
Section 7704 of the Internal Revenue Code (the "Code") provides that
publicly traded partnerships shall, as a general rule, be taxed as corporations
despite the fact that they are not classified as corporations under Section 7701
of the Code. Section 7704 of the Code provides an exception to this general
rule for a publicly traded partnership if 90% or more of its gross income for
every taxable year consists of "qualifying income" (the "Qualifying Income
Exception"). For purposes of this exception, "qualifying income" includes
income and gains derived from the exploration, development, mining or
production, processing, refining, transportation (including pipelines) or
marketing of any mineral or natural resource. Other types of "qualifying
income" include interest (other than from a financial business or interest based
on profits of the borrower), dividends, real property rents, gains from the sale
of real property, including real property held by one considered to be a
"dealer" in such property, and gains from the sale or other disposition of
capital assets held for the production of income that otherwise constitutes
"qualifying income".
No ruling has been or will be sought from the IRS and the IRS has made no
determination as to Rio Vista's classification as a partnership for federal
income tax purposes or whether Rio Vista's operations generate a minimum of 90%
of "qualifying income" under Section 7704 of the Code.
If Rio Vista were classified as a corporation in any taxable year, either
as a result of a failure to meet the Qualifying Income Exception or otherwise,
Rio Vista's items of income, gain, loss and deduction would be reflected only on
Rio Vista's tax return rather than being passed through to Rio Vista's
unitholders, and Rio Vista's net income would be taxed at corporate rates.
If Rio Vista were treated as a corporation for federal income tax purposes,
Rio Vista would pay tax on income at corporate rates, which is currently a
maximum of 35%. Distributions to unitholders would generally be taxed again as
corporate distributions, and no income, gains, losses, or deductions would flow
through to the unitholders. Because a tax would be imposed upon Rio Vista as a
corporation, the cash available for distribution to unitholders would be
substantially reduced and Rio Vista's ability to make minimum quarterly
distributions would be impaired. Consequently, treatment of Rio Vista as a
corporation would result in a material reduction in the anticipated cash flow
and after-tax return to unitholders and therefore would likely result in a
substantial reduction in the value of Rio Vista's common units.
Current law may change so as to cause Rio Vista to be taxable as a
corporation for federal income tax purposes or otherwise subject Rio Vista to
entity-level taxation. The Agreement provides that, if a law is enacted or
existing law is modified or interpreted in a manner that subject Rio Vista to
taxation as a corporation or otherwise subjects Rio Vista to entity-level
taxation for federal, state or local income tax purposes, then the minimum
quarterly distribution amount and the target distribution amount will be
adjusted to reflect the impact of that law on Rio Vista.
Pipeline Lease. The Pipeline Lease currently expires on December 31, 2013,
pursuant to an amendment (the "Pipeline Lease Amendment") entered into between
the Company and Seadrift on May 21, 1997, which became effective on January 1,
1999 (the "Effective Date"). The Pipeline Lease Amendment provides, among other
things, for additional storage access and inter-connection with another pipeline
controlled by Seadrift, thereby providing greater access to and from the Leased
Pipeline. Pursuant to the Pipeline Lease Amendment, the Company's fixed annual
rent for the use of the Leased Pipeline is $1.0 million including monthly
service payments of $8,000 through March 2004. The service payments are subject
to an annual adjustment based on a labor cost index and an electric power cost
index. The Company is also required to pay for a minimum volume of storage of
$300,000 per year (based on reserved storage of 8.4 million gallons) beginning
January 1, 2000. In connection with the Pipeline Lease, the Company may
reserve up to 21.0 million gallons each year thereafter provided that the
Company notifies Seadrift in advance.
The Pipeline Lease Amendment provides for variable rental increases based
on monthly volumes purchased and flowing into the Leased Pipeline and storage
utilized. The Company believes that the Pipeline Lease Amendment provides the
Company increased flexibility in negotiating sales and supply agreements with
its customers and suppliers.
The Company at its own expense, installed a mid-line pump station which
included the installation of additional piping, meters, valves, analyzers and
pumps along the Leased Pipeline to increase the capacity of the Leased Pipeline.
The Leased Pipeline's capacity is estimated to be between 300 million and 360
million gallons per year.
32
Other. The Company intends to upgrade its computer and information systems
at a total estimated cost of approximately $350,000.
Acquisition of Mexican Subsidiaries. Effective April 1, 2001, the Company
completed the purchase of 100% of the outstanding common stock of both Termatsal
and PennMex (the "Mexican Subsidiaries"), previous affiliates of the Company
which were principally owned by a former officer and director (see note D to the
consolidated financial statements). The Company paid a nominal purchase price
of approximately $5,000 for each Mexican subsidiary. As a result of the
acquisition, the Company has included the results of the Mexican Subsidiaries in
its unaudited consolidated financial statements for the three ended October 2004
and 2003. Since inception through the acquisition date, the operations of the
Mexican Subsidiaries had been funded by the Company and such amounts funded were
included in the Company's consolidated financial statements. Therefore there
are no material differences between the amounts previously reported by the
Company and the amounts that would have been reported by the Company had the
Mexican Subsidiaries been consolidated since inception.
During July 2003, the Company acquired an option to purchase Tergas, an
affiliate 95% owned by Mr. Soriano and the remaining balance owned by Mr.
Abelardo Mier, a consultant of the Company, for a nominal price of approximately
$5,000. Since inception the operations of Tergas have been funded by the
Company and the assets, liabilities and results of operations of Tergas are
included in the Company's consolidated financial statements.
Mexican Operations. Under current Mexican law, foreign ownership of
Mexican entities involved in the distribution of LPG or the operation of LPG
terminal facilities is prohibited. Foreign ownership is permitted in the
transportation and storage of LPG. Mexican law also provides that a single
entity is not permitted to participate in more than one of the defined LPG
activities (transportation, storage or distribution). PennMex has a
transportation permit and Termatsal owns, leases, or is in the process of
obtaining the land or rights of way used in the construction of the Mexican
portion of the US-Mexico Pipelines, and owns the Mexican portion of the assets
comprising the US-Mexico Pipelines and the Matamoros Terminal Facility. The
Company's consolidated Mexican affiliate, Tergas, S.A. de C.V. ("Tergas"), has
been granted the permit to operate the Matamoros Terminal Facility and the
Company relies on Tergas' permit to continue its delivery of LPG at the
Matamoros Terminal Facility. The Company pays Tergas its actual cost for
distribution services at the Matamoros Terminal Facility plus a small profit.
Through its operations in Mexico and the operations of the Mexican
Subsidiaries and Tergas, a consolidated affiliate, the Company is subject to the
tax laws of Mexico which, among other things, require that the Company comply
with transfer pricing rules, the payment of income, asset and ad valorem taxes,
and possibly taxes on distributions in excess of earnings. In addition,
distributions to foreign corporations, including dividends and interest payments
may be subject to Mexican withholding taxes.
Deregulation of the LPG Industry in Mexico. The Mexican petroleum industry
is governed by the Ley Reglarmentaria del Art culo 27 Constitutional en el Ramo
del Petr leo (the Regulatory Law to Article 27 of the Constitution of Mexico
concerning Petroleum Affairs (the "Regulatory Law")), and Ley Org nica del Petr
leos Mexicanos y Organismos Subsidiarios (the Organic Law of Petr leos Mexicanos
and Subsidiary Entities (the "Organic Law")). Under Mexican law and related
regulations, PEMEX is entrusted with the central planning and the strategic
management of Mexico's petroleum industry, including importation, sales and
transportation of LPG. In carrying out this role, PEMEX controls pricing and
distribution of various petrochemical products, including LPG.
Beginning in 1995, as part of a national privatization program, the
Regulatory Law was amended to permit private entities to transport, store and
distribute natural gas with the approval of the Ministry of Energy. As part of
this national privatization program, the Mexican Government is expected to
deregulate the LPG market ("Deregulation"). In June 1999, the Regulatory Law
for LPG was changed to permit foreign entities to participate without limitation
in the defined LPG activities related to transportation and storage. However,
foreign entities are prohibited from participating in the distribution of LPG in
Mexico. Upon Deregulation, Mexican entities will be able to import LPG into
Mexico. Under Mexican law, a single entity is not permitted to participate in
more than one of the defined LPG activities (transportation, storage and
distribution). The Company or its consolidated affiliate expect to sell LPG
directly to independent Mexican distributors as well as PMI upon Deregulation.
The Company anticipates that the independent Mexican distributors will be
required to obtain authorization from the Mexican government for the importation
of LPG upon Deregulation prior to entering into contracts with the Company.
33
During July 2001, the Mexican government announced that it would begin to
accept applications from Mexican companies for permits to allow for the
importation of LPG pursuant to provisions already provided for under existing
Mexican law.
In connection with the above, in August 2001, Tergas received a one year
permit from the Mexican government to import LPG. During September 2001, the
Mexican government decided to delay the implementation of Deregulation and asked
Tergas to defer use of the permit and as a result, the Company did not sell LPG
to distributors other than PMI. In March 2002, the Mexican government again
announced its intention to issue permits for free importation of LPG into Mexico
by distributors and others beginning August 2002, which was again delayed. To
date the Mexican government has continued to delay implementation of
Deregulation. Tergas' permit to import LPG expired during August 2002. Tergas
intends to obtain a new permit when the Mexican government again begins to
accept applications. As a result of the foregoing, it is uncertain as to when,
if ever, Deregulation will actually occur and the effect, if any, it will have
on the Company. However, should Deregulation occur, it is the Company's
intention to sell LPG directly to distributors in Mexico as well as to PMI.
The point of sale for LPG which flows through the US-Mexico Pipelines for
delivery to the Matamoros Terminal Facility is the United States-Mexico border.
For LPG delivered into Mexico, PMI is the importer of record.
Private Placements and Other Transactions. In connection with the Penn
Octane Board Plan, during August 2004 the Board granted warrants to purchase
20,000 shares of common stock of Penn Octane at exercise prices of $1.93 and
$1.94 per share to outside directors. The warrants expire in August 2009.
Based on the provisions of APB 25, no compensation expense was recorded for
these warrants.
On September 30, 2004, pursuant to the terms of an employment agreement
dated as of May 13, 2003 with Mr. Shore, the Company issued warrants to purchase
763,737 shares of Penn Octane's common stock at an exercise price of $1.14 per
share. The warrants expire on July 10, 2006. Based on the provisions of APB
25, no compensation expense was recorded for these warrants.
In connection with the Penn Octane Board Plan, during November 2004 the
Board granted warrants to purchase 10,000 shares of common stock of Penn Octane
at exercise price of $1.30 per share to an outside director. The warrants
expire in November 2009. Based on the provisions of APB 25, no compensation
expense was recorded for these warrants.
In connection with warrants previously issued by the Company, certain of
these warrants contain a call provision whereby the Company has the right to
purchase the warrants for a nominal price if the holder of the warrants does not
elect to exercise the warrants during the call provision period.
OPTIONS AND WARRANTS OF RIO VISTA
GENERAL PARTNER OPTIONS. Penn Octane's 100% interest in the General Partner
is expected to be decreased to 50% as a result of the exercise by Shore Capital
LLC ("Shore Capital") an affiliate of Mr. Shore, and Mr. Richter of options to
each acquire 25% of the General Partner (the "General Partner Options"). Mr.
Shore and Mr. Richter are each members of the board of directors of Penn Octane
and the board of managers of the General Partner. It is anticipated that Mr.
Richter and Shore Capital will exercise their General Partner Options in the
near future. The exercise price for each option is approximately $82,000. Based
on the provisions of APB 25, the Company recorded approximately $41,000 of
compensation cost related to these options. Penn Octane will retain voting
control of the General Partner pursuant to a voting agreement.
COMMON UNIT WARRANTS. In connection with Mr. Shore's employment agreement
with Penn Octane, Shore Capital received warrants to acquire 97,415 common units
of Rio Vista at $8.47 per unit. Based on the provisions of APB 25, Rio Vista
recorded $343,875 of compensation cost related to these warrants on October 1,
2004, the initial exercise date. The warrants expire on July 10, 2006.
34
Fuel Sales Business. During June 2004, the Company began the Fuel Sales
Business. The Company sells Fuel Products through transactional, bulk and/or
rack transactions. Typical transactional and bulk sales are made based on a
predetermined net spread between the purchase and sales price over posted
monthly variable prices and/or daily spot prices. Rack sales transactions are
based on variable sale prices charged by the Company which are tied to posted
daily spot prices and purchase costs which are based on a monthly average or 3
day average based on posted prices. The Company pays pipeline and terminal fees
based on regulated rates.
The Fuel Sales Business on the west coast of the United States is
characterized by limited pipeline and terminal space to move sufficient Fuel
Products to locations where demand for Fuel Products exists. The Company has
the ability to access to certain pipeline and terminal systems located in
California, Arizona, Nevada and Texas, where it is able to deliver its Fuel
Products. The markets where the Company has targeted its products are generally
in areas where the Fuel Products are difficult to deliver due to the
infrastructure limitations and accordingly, the Company's access provides an
advantage over other potential competitors who may not have access to these
pipelines or terminals. In addition, the Company's supply contracts provide it
with greater flexibility to manage changes in the prices of the Fuel Products.
The Company believes it has an advantage over other competitors based on its
favorable supply contracts and existing access to certain pipelines and
terminals.
For bulk and transactional sales, the Company enters into individual sales
contracts for each sale. Rack sales are subject to credit limitations imposed
on each individual buyer by the Company. The Company has several supply
contracts for each of the Fuel Products it sells. The supply contracts are
for annual periods with flexible volumes but they may be terminated sooner by
the supplier if the Company consistently fails to purchase minimum volumes of
Fuel Products.
The ability of the Company to participate in the Fuel Sales Business is
largely dependent on the Company's ability to finance its supplies. Currently,
the Company utilizes the RZB Credit Facility to finance the purchases of Fuel
Products. Based on the Company's LPG purchase commitments, increases in the
costs of LPG and/or the increases in the costs of Fuel Products, the amount of
financing available for the Fuel Sales Business may be reduced.
Federal and State agencies require the Company to obtain the necessary
regulatory and other approvals for its Fuel Sales Business.
The Spin-Off. On July 10, 2003, Penn Octane formed Rio Vista, a Delaware
limited partnership, the General Partner, a Delaware limited liability company,
RVOP, a Delaware limited partnership (0.1% owned by Rio Vista Operating GP LLC
and 99.9% owned by Rio Vista) and Rio Vista Operating GP LLC, a Delaware limited
liability company (wholly owned by Rio Vista) for the purpose of completing the
Spin-Off. During September 2003, the Company's Board of Directors and the
Independent Committee of its Board of Directors formally approved the terms of
the Spin-Off (see below) and Rio Vista filed a Form 10 registration statement
with the Securities and Exchange Commission ("SEC"). On September 30, 2004 the
Common Units of Rio Vista were distributed to Penn Octane's stockholders.
As a result of the Spin-Off, Rio Vista owns and operates the LPG,
distribution, transportation and marketing business previously conducted by Penn
Octane. Rio Vista sells LPG directly to PMI and purchases LPG from Penn Octane
under a long-term supply agreement.
INTERCOMPANY PURCHASE AGREEMENT FOR LPG
Penn Octane entered into a long-term supply agreement with Rio Vista
pursuant to which Rio Vista agrees to purchase all of its LPG requirements for
sales which utilize the assets transferred to Rio Vista by Penn Octane to the
extent Penn Octane is able to supply such LPG requirements. This agreement
further provides that Rio Vista has no obligation to purchase LPG from Penn
Octane to the extent the distribution of such LPG to Rio Vista's customers would
not require the use of any of the assets Penn Octane contributed to Rio Vista or
Penn Octane ceases to have the right to access the Seadrift pipeline.
35
OMNIBUS AGREEMENT
In connection with the Spin-Off, Penn Octane entered into an Omnibus
Agreement with Rio Vista and its subsidiaries that governs, among other things,
indemnification obligations among the parties to the agreement, related party
transactions, the provision of general administration and support services by
Penn Octane.
The Omnibus Agreement prohibits Rio Vista from entering into any material
agreement with Penn Octane without the prior approval of the conflicts committee
of the board of managers of the General Partner. For purposes of the Omnibus
Agreement, the term material agreements means any agreement between Rio Vista
and Penn Octane that requires aggregate annual payments in excess of $100,000.
The Omnibus Agreement may be amended by written agreement of the parties;
provided, however that it may not be amended without the approval of the
conflicts committee of the General Partner if such amendment would adversely
affect the unitholders of Rio Vista. The Omnibus Agreement has an initial term
of five years that automatically renews for successive five-year terms and,
other than the indemnification provisions, will terminate if Rio Vista is no
longer an affiliate of Penn Octane.
TRANSFERRED ASSETS
The following assets of Penn Octane were transferred to the operating
subsidiary of Rio Vista on September 30, 2004:
Brownsville Terminal Facilities
US Mexico Pipelines, including various rights of way and land obtained in
connection with operation of US Pipelines between Brownsville Terminal
Facility and the US Border
Inventory located in storage tanks and pipelines located in Brownsville
(and extending to storage and pipelines located in assets held by the
Mexican subsidiaries)
Contracts and Leases (assumed and/or assigned):
Lease Agreements:
Port of Brownsville:
LPG Terminal Facility
Tank Farm Lease
US State Department Permit
Other licenses and permits in connection with ownership and operation
of the US pipelines between Brownsville and US border
Investment in Subsidiaries:
Penn Octane de Mexico, S. de R.L. de C.V., consisting primarily of a
permit to transport LPG from the Mexican Border to the Matamoros
Terminal Facility
Termatsal, S. de R.L. de C.V., consisting primarily of land, LPG
terminal facilities, Mexican pipelines and rights of way, and
equipment used in the transportation of LPG from the Mexican
border to the Matamoros terminal facility and various LPG
terminal equipment
Penn Octane International LLC
Option to acquire Tergas, S.A. de C.V.
Realization of Assets. The accompanying consolidated financial statements
have been prepared in conformity with accounting principles generally accepted
in the United States of America, which contemplate continuation of the Company
as a going concern. The Company has had an accumulated deficit since inception
and has historically had a deficit in working capital. In addition,
substantially all of the Company's assets are pledged or committed to be pledged
as collateral on existing debt in connection with the Restructured Notes, the
$280,000 Notes and the RZB Credit Facility and therefore, the Company maybe
unable to obtain additional financing collateralized by those assets. The RZB
Credit Facility may be insufficient to finance the Company's LPG sales and/or
Fuel Products sales, assuming increases in product costs per gallon, or
volumetric growth in product sales, and maybe terminated by RZB with 90 days
notice.
36
Since April 1, 2004, the Company has been operating under the Monthly 2004
Contracts with PMI (see note J). The monthly volumes of LPG sold to PMI since
April 1, 2004 have been materially less than historical levels. As discussed in
note J, the Company has LPG supply contracts which require it to purchase
volumes of LPG materially in excess of monthly volumes under the Monthly 2004
Contracts (Mismatched LPG). The volume of the Mismatched LPG was materially
lower prior to April 1, 2004 than subsequent to April 1, 2004, and the Company
was able to dispose of the Mismatched LPG prior to April 1, 2004 at acceptable
margins. The Company may incur additional reductions of gross profits on sales
of LPG in disposing of the Mismatched LPG if (i) the volume of LPG sold under
the Monthly 2004 Contracts declines below the current levels of approximately
11,000,000 gallons per month and/or the margins are materially reduced and/or
(ii) the Company cannot successfully reduce the minimum volumes and/or purchase
costs required under the LPG supply agreements. The Company may not have
sufficient cash flow or available credit to absorb such reductions in gross
profit.
The Company's cash flow has been reduced as a result of lower volumes of
sales to PMI. Additionally, the Company will also incur the additional public
company compliance and income tax preparation costs for Rio Vista. As a
result, the Company may not have sufficient cash flow to make distributions to
Rio Vista's unitholders and to pay Penn Octane's obligations when due. In the
event Penn Octane does not pay its obligations when due, Rio Vista's guarantees
to Penn Octane and Penn Octane's creditors may be triggered. Accordingly, Rio
Vista may be required to pay such obligations of Penn Octane to avoid
foreclosure of its assets by Penn Octane's creditors. If the Company's revenues
and other sources of liquidity are not adequate to pay Penn Octane's
obligations, Rio Vista may be required to reduce or eliminate the quarterly
distributions to unitholders and Penn Octane or Rio Vista may be required to
raise additional funds to avoid foreclosure. There can be no assurance that
such additional funding will be available on terms attractive to either Penn
Octane or Rio Vista or available at all.
In view of the matters described in the preceding paragraphs,
recoverability of the recorded asset amounts shown in the accompanying
consolidated balance sheet is dependent upon the ability of the Company to
generate sufficient cash flow through operations or additional debt or equity
financing to pay its liabilities and obligations when due. The ability for the
Company to generate sufficient cash flows is significantly dependent on the
continued sale of LPG to PMI at acceptable monthly sales volumes and margins,
the success of the Fuel Sales Business and the adequacy of the RZB Credit
Facility to finance such sales. The consolidated financial statements do not
include any adjustments related to the recoverability and classification of
recorded asset amounts or amounts and classification of liabilities that might
be necessary should the Company be unable to continue in existence.
To provide the Company with the ability it believes necessary to continue
in existence, management is negotiating with PMI to increase LPG sales at
acceptable monthly volumes and margins. In addition, management is taking steps
to (i) expand its Fuel Sales Business, (ii) further diversify its operations to
reduce dependency on sales of LPG, (iii) increase the amount of financing for
its products and operations, and (iv) raise additional debt and/or equity
capital.
IMPACT OF INFLATION
Inflation in the United States has been relatively low in recent years and
did not have a material impact on the unaudited consolidated financial
statements of the Company. However, inflation remains a factor in the United
States economy and could increase the Company's cost to acquire or replace
property, plant and equipment as well as our labor and supply costs.
37
ENVIRONMENTAL MATTERS
The Company's operations are subject to environmental laws and regulations
adopted by various governmental authorities in the jurisdictions in which these
operations are conducted. Under the Omnibus Agreement, Penn Octane will
indemnify Rio Vista for five years after the completion of the Spin-Off against
certain potential environmental liabilities associated with the assets it
contributed to Rio Vista relating to events or conditions that existed before
the completion of the Spin-Off.
RECENTLY ISSUED FINANCIAL ACCOUNTING STANDARDS
During 2004, the Company adopted Financial Accounting Standards Board
Interpretation No. 46, "Consolidation of Variable Entities" ("FIN 46"), which
was amended by FIN 46R. This interpretation of Accounting Research Bulletin No.
51, "Consolidated Financial Statements", addresses consolidation by business
enterprises of variable interest entities ("VIE") that do not have sufficient
equity investment at risk to permit the entity to finance its activities without
additional subordinated financial support. FIN 46R requires the beneficiary of
a VIE to consolidate in its financial statements the assets, liabilities and
results of operations of the VIE. Tergas, an affiliate of the Company, is a VIE
and therefore, its assets, liabilities and results of operations have been
included in the accompanying unaudited consolidated financial statements of the
Company.
CRITICAL ACCOUNTING POLICIES
The unaudited consolidated financial statements of the Company reflect the
selection and application of accounting policies which require management to
make significant estimates and judgments. See note B to the Company's Annual
Report on Form 10-K for the fiscal year ended July 31, 2004, "Summary of
Significant Accounting Policies". The Company believes that the following
reflect the more critical accounting policies that affect the financial position
and results of operations.
Revenues recognition - the Company expects in the future to enter into
sales agreements to sell LPG for future delivery. The Company will not
record sales until the LPG is delivered to the customer.
Impairment of long-lived assets - The determination of whether impairment
has occurred is based on an estimate of undiscounted cash flows
attributable to assets in future periods. If impairment has occurred, the
amount of the impairment loss recognized will be determined by estimating
the fair value of the assets and recording a loss if the fair value is less
than the carrying value. Assessments of impairment are subject to
management's judgments and based on estimates that management is required
to make.
Depreciation and amortization expenses - Property, plant and equipment are
carried at cost less accumulated depreciation and amortization.
Depreciation and amortization rates are based on management's estimate of
the future utilization and useful lives of the assets.
Stock-based compensation - The Company accounts for stock-based
compensation using the provisions of ABP 25 (intrinsic value method), which
is permitted by SFAS 123. The difference in net income, if any, between the
intrinsic value method and the method provided for by SFAS 123 (fair value
method) is required to be disclosed in the financial statements on an
annual and interim basis as a result of the issuance of SFAS 148.
Allowance for doubtful accounts - The carrying value of trade accounts
receivable is based on estimated fair value. The determination of fair
value is subject to management's judgments and is based on estimates that
management is required to make.
38
STATEMENT BY MANAGEMENT CONCERNING REVIEW OF INTERIM INFORMATION BY INDEPENDENT
CERTIFIED PUBLIC ACCOUNTANTS.
The unaudited consolidated financial statements included in this filing on
Form 10-Q have been reviewed by Burton McCumber & Cortez, L.L.P., independent
certified public accountants, in accordance with established professional
standards and procedures for such review. The report of Burton McCumber &
Cortez, L.L.P. commenting on their review, accompanies the unaudited
consolidated financial statements included in Item 1 of Part I.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
To the extent that the Company maintains quantities of LPG inventory in
excess of commitments for quantities of undelivered LPG and/or has commitments
for undelivered LPG in excess of inventory balances, the Company is exposed to
market risk related to the volatility of LPG prices. In the event that
inventory balances exceed commitments for undelivered LPG, during periods of
falling LPG prices, the Company may sell excess inventory to customers to reduce
the risk of these price fluctuations. In the event that commitments for
undelivered LPG exceed inventory balances, the Company may purchase contracts
which protect the Company against future price increases of LPG.
The Company does not maintain quantities of LPG inventory in excess of
quantities actually ordered by PMI. Therefore, the Company has not currently
entered into and does not currently expect to enter into any arrangements in the
future to mitigate the impact of commodity price risk.
To the extent the Company maintains quantities of Fuel Products inventory
in excess of commitments for quantities of undelivered Fuel Products, the
Company is exposed to market risk related to the volatility of Fuel Product
prices. In the event that inventory balances exceed commitments for undelivered
Fuel Products, during periods of falling Fuel Products prices, the Company may
sell excess inventory to customers to reduce the risk of these price
fluctuations.
The Company has historically borrowed only at fixed interest rates. All
current interest bearing debt is at a fixed rate. Trade accounts receivable
from the Company's limited number of customers and the Company's trade and other
accounts payable do not bear interest. The Company's credit facility with RZB
does not bear interest since generally no cash advances are made to the Company
by RZB. Fees paid to RZB for letters of credit are based on a fixed schedule as
provided in the Company's agreement with RZB. Therefore, the Company currently
has limited, if any, interest rate risk.
The Company routinely converts U.S. dollars into Mexican pesos to pay
terminal operating costs and income taxes. Such costs have historically been
less than $1 million per year and the Company expects such costs will remain at
less than $1 million in any year. The Company does not maintain Mexican peso
bank accounts with other than nominal balances. Therefore, the Company has
limited, if any, risk related to foreign currency exchange rates.
ITEM 4. CONTROLS AND PROCEDURES.
The Company's management, including the principal executive officer and
principal financial officer, conducted an evaluation of the Company's disclosure
controls and procedures, as such term is defined under Rule 13a-15 promulgated
under the Securities Exchange Act of 1934, as of the end of the period. Based
on their evaluation, the Company's principal executive officer and principal
accounting officer concluded that the Company's disclosure controls and
procedures are effective.
There have been no significant changes (including corrective actions with
regard to significant deficiencies or material weaknesses) in the Company's
internal controls or in other factors that could significantly affect these
controls subsequent to the date of the evaluation referenced in paragraph above.
39
PART II
ITEM 1. LEGAL PROCEEDINGS
See note L to the Company's Annual Report on Form 10-K for the fiscal
year ended July 31, 2004.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
See note G to the accompanying unaudited consolidated financial
statements and notes J and K to the Company's Annual Report on Form
10-K for the fiscal year ended July 31, 2004, for information
concerning certain sales of Securities.
In connection with the issuances of securities discussed in note G to
the accompanying unaudited consolidated financial statements, the
transactions were exempt under registration under the Securities Act
of 1933, as amended pursuant to Section 4(2) thereof because the
issuance did not involve any public offering of securities.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. Exhibits
THE FOLLOWING EXHIBITS ARE FILED AS PART OF THIS REPORT:
Exhibit No.
- -----------
15 Accountant's Acknowledgment
31.1 Certification Pursuant to Rule 13a - 14(a) / 15d - 14(a) of the Exchange Act.
31.2 Certification Pursuant to Rule 13a - 14(a) / 15d - 14(a) of the Exchange Act.
32 Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to
Section 906 of the Sarbanes -Oxley Act of 2002.
40
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
PENN OCTANE CORPORATION
December 15, 2004 By: /s/Ian T. Bothwell
----------------------------------------
Ian T. Bothwell
Vice President, Treasurer, Assistant
Secretary, Chief Financial Officer
41