UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2004
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to

 

Commission File Number 0-9204

 

EXCO RESOURCES, INC.

(Exact name of registrant as specified in its charter)

 

Texas		74-1492779
(State of incorporation)		(I.R.S. Employer Identification No.)
12377 Merit Drive Suite 1700, LB 82 Dallas, Texas		75251
(Address of principal executive offices)		(Zip Code)

 

(214) 368-2084

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

YES ý   NO o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

YES o   NO ý

 

The number of shares of common stock, par value $0.01 per share, outstanding at October 31, 2004 was 1,000.

 

 

EXCO RESOURCES, INC.

 

INDEX

 

PART I.	FINANCIAL INFORMATION (1)
Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Balance Sheets at December 31, 2003 and September 30, 2004
	Condensed Consolidated Statements of Operations for the 28 day period from July 1, 2003 to July 28, 2003 and the 64 day period from July 29, 2003 to September 30, 2003; the 209 day period from January 1, 2003 to July 28, 2003 and the 64 day period from July 29, 2003 to September 30, 2003; and the Three and Nine Months Ended September 30, 2004
	Condensed Consolidated Statements of Cash Flow for the 28 day period from July 1, 2003 to July 28, 2003 and the 64 day period from July 29, 2003 to September 30, 2003; the 209 day period from January 1, 2003 to July 28, 2003 and the 64 day period from July 29, 2003 to September 30, 2003; and the Three and Nine Months Ended September 30, 2004
	Condensed Consolidated Statements of Comprehensive Income for the 28 day period from July 1, 2003 to July 28, 2003 and the 64 day period from July 29, 2003 to September 30, 2003; the 209 day period from January 1, 2003 to July 28, 2003 and the 64 day period from July 29, 2003 to September 30, 2003; and the Three and Nine Months Ended September 30, 2004
	Notes to Condensed Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosure About Market Risk
Item 4.	Controls and Procedures
PART II.	OTHER INFORMATION
Item 5.	Other Information
Item 6.	Exhibits
Signatures
Index to Exhibits

 

(1)          Financial information for the periods prior to July 29, 2003, the date of the going private transaction, represents predecessor basis financial statements.  See Note 1 to the condensed consolidated financial statements.

 

2

 

PART I—FINANCIAL INFORMATION

 

Item 1.  Financial Statements (Unaudited)

 

EXCO RESOURCES, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

 

		December 31, 2003			September 30, 2004
					(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$	7,333		$	25,704
Accounts receivable:
Oil and natural gas sales		13,514			25,788
Joint interest		3,857			3,980
Interest and other		1,895			1,971
Oil and natural gas derivatives		705			190
Marketable securities		818			63
Other		3,447			3,945
Total current assets		31,569			61,641
Oil and natural gas properties (full cost accounting method):
Unproved oil and natural gas properties		9,195			20,937
Proved developed and undeveloped oil and natural gas properties		416,679			734,554
Accumulated depreciation, depletion and amortization		(11,931		)	(46,892		)
Oil and natural gas properties, net		413,943			708,599
Gas gathering assets, net		—			17,731
Office and field equipment, net		1,101			5,800
Deferred financing costs, net		1,565			11,411
Oil and natural gas derivatives		204			7
Goodwill		53,346			51,510
Other assets		3,302			114
Total assets		$	505,030		$	856,813

 

See accompanying notes.

 

3

 

EXCO RESOURCES, INC.

 

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

 

		December 31, 2003			September 30, 2004
					(Unaudited)
Liabilities and Stockholder’s Equity
Current liabilities:
Accounts payable and accrued liabilities		$	25,308		$	46,465
Revenues and royalties payable		3,350			7,863
Income taxes payable		3,726			6,958
Current portion of asset retirement obligations		—			1,325
Oil, natural gas and interest rate derivatives		12,804			46,402
Total current liabilities		45,188			109,012
Long-term debt		207,951			29,289
7 1/4% Senior notes due 2011		—			453,051
Asset retirement obligations and other long-term liabilities		18,343			25,778
Deferred income taxes		45,899			35,506
Oil and natural gas derivatives		3,780			32,214
Commitments and contingencies		—			—
Stockholder’s equity:
Common stock, $.01 par value:
Authorized shares - 100,000
Issued and outstanding shares - 1,000 at December 31, 2003 and September 30, 2004		1			1
Capital contributed by EXCO Holdings Inc.		172,045			172,045
Retained earnings (deficit)		4,177			(13,223		)
Accumulated other comprehensive income (loss):
Foreign currency translation adjustments		7,680			13,147
Unrealized loss on equity investments		(34		)	(8		)
Total stockholder’s equity		183,869			171,962
Total liabilities and stockholder’s equity		$	505,030		$	856,813

 

See accompanying notes.

 

4

 

EXCO RESOURCES, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited, in thousands, except per share amounts)

 

		For the 28 Day Period From July 1 to July 28, 2003			For the 64 Day Period From July 29 to September 30, 2003			Three Months Ended September 30, 2004			For the 209 Day Period From January 1 to July 28, 2003			For the 64 Day Period From July 29 to September 30, 2003			Nine Months Ended September 30, 2004
		(Predecessor)			(Successor)			(Successor)			(Predecessor)			(Successor)			(Successor)
Revenues:
Oil and natural gas		$	8,740		$	19,493		$	59,376		$	61,416		$	19,493		$	166,603
Commodity price risk management activities		—			329			(37,518		)	—			329			(81,999		)
Other income (loss)		368			60			5,784			(1,033		)	60			7,498
Total revenues		9,108			19,882			27,642			60,383			19,882			92,102
Costs and expenses:
Oil and natural gas production		2,387			5,034			12,629			19,793			5,034			35,327
Depreciation, depletion and amortization		1,876			4,949			12,427			12,022			4,949			35,518
Accretion of discount on asset retirement obligations		112			201			423			737			201			1,259
General and administrative		11,628			2,308			5,072			19,272			2,308			15,610
Interest		586			1,416			9,099			2,981			1,416			27,144
Total costs and expenses		16,589			13,908			39,650			54,805			13,908			114,858
Income (loss) before income taxes		(7,481		)	5,974			(12,008		)	5,578			5,974			(22,756		)
Income tax expense (benefit)		(446		)	2,248			(918		)	4,801			2,248			(5,356		)
Income (loss) before cumulative effect of change in accounting principle		(7,035		)	3,726				(11,090	)	777			3,726			(17,400		)
Cumulative effect of change in accounting principle, net of income taxes		—			—			—			255			—			—
Net income (loss)		(7,035		)	$	3,726		$	(11,090	)	1,032			$	3,726		$	(17,400	)
Dividends on preferred stock		—									2,620
Earnings (loss) on common stock		$	(7,035	)							$	(1,588	)
Basic earnings (loss) per share		$	(0.58	)							$	(0.20	)
Diluted income (loss) per share		$	(0.58	)							$	(0.20	)
Weighted average number of common and common equivalent shares outstanding:
Basic		12,144									8,084
Diluted		12,144									8,084

 

See accompanying notes.

 

5

 

EXCO RESOURCES, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

 

		For the 28 Day Period From July 1 to July 28, 2003			For the 64 Day Period From July 29 to September 30, 2003			Three Months Ended September 30, 2004			For the 209 Day Period From January 1 to July 28, 2003			For the 64 Day Period From July 29 to September 30, 2003			Nine Months Ended September 30, 2004
		(Predecessor)			(Successor)			(Successor)			(Predecessor)			(Successor)			(Successor)
Operating Activities:
Net income (loss)		$	(7,035	)	$	3,726		$	(11,090	)	$	1,032		$	3,726		$	(17,400	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation, depletion and amortization		1,876			4,949			12,427			12,022			4,949			35,518
Stock option compensation expense		9,020			—			—			9,020			—			—
Accretion of discount on asset retirement obligations		112			201			423			737			201			1,259
Non-cash changes in fair value of derivatives		—			(2,694		)	28,430			—			(2,694		)	60,353
Cumulative effect of change in accounting principle, net of income taxes		—			—			—			(255		)	—			—
Deferred income taxes		1,356			995			(1,872		)	2,710			995			(11,123		)
Amortization of deferred financing costs		—			—			473			—			—			3,429
Proceeds from sale of Enron claim		—			—			—			—			—			4,750
(Income) expense from derivative ineffectiveness and terminated hedges, net		(349		)	—			—			(187		)	—			—
Other, net		(245		)	—			(15		)	(40		)	—			(14		)
Foreign currency transaction gain		—			—			(5,604		)	—			—			(5,827		)
Effect of changes in:
Accounts receivable		(2,817		)	4,446			(1,124		)	(296		)	4,446			(1,520		)
Other current assets		(688		)	424			349			(1,573		)	424			381
Accounts payable and other current liabilities		(5,251		)	238			2,557			(2,752		)	238			18,606
Net cash provided (used) by operating activities		(4,021		)	12,285			24,954			20,418			12,285			88,412
Investing Activities:
Acquisition of North Coast Energy, Inc., less cash acquired		—			—			—			—			—			(215,133		)
Additions to oil and natural gas properties, gathering systems and equipment		(2,181		)	(13,407		)	(81,968		)	(29,773		)	(13,407		)	(144,140		)
Proceeds from dispositions of property and equipment		1,590			235			9,606			6,020			235			23,418
Advances/investments with affiliates		—			1,995			16			—			1,995			76
Proceeds from sale of marketable securities		—			—			515			—			—			1,296
Other investing activities		337			(389		)	538			233			(389		)	423
Net cash used in investing activities		(254		)	(11,566		)	(71,293		)	(23,520		)	(11,566		)	(334,060		)
Financing Activities:
Proceeds from long-term debt		20,871			5,735			51,258			46,337			5,735			511,609
Payments on long-term debt		—			(6,100		)	(22,653		)	(22,599		)	(6,100		)	(232,216		)
Proceeds from exercise of stock options		12,737			—			—			12,737			—			—
Purchase of common stock from employees in connection with the merger		(17,874		)	—			—			(17,874		)	—			—
Purchase of director and employee stock options in connection with the merger		(3,567		)	—			—			(3,567		)	—			—
Preferred stock dividends		—			—			—			(2,620		)	—			—
Payment of fees and expenses in connection with the merger		(563		)	—			—			(563		)	—			—
Deferred financing costs		(1,034		)	(183		)	54			(2,041		)	(183		)	(13,128		)
Other financing activities		131			—			—			172			—			—
Net cash provided (used) by financing activities		10,701			(548		)	28,659			9,982			(548		)	266,265
Net increase (decrease) in cash		6,426			171			(17,680		)	6,880			171			20,617
Effect of exchange rates on cash and cash equivalents		(55		)	143			562			58			143			(2,246		)
Cash at beginning of period		2,509			8,880			42,822			1,942			8,880			7,333
Cash at end of period		$	8,880		$	9,194		$	25,704		$	8,880		$	9,194		$	25,704
Supplemental Cash Flow Information:
Interest paid		$	725		$	1,451		$	284		$	2,931		$	1,451		$	18,654
Income taxes paid		$	—		$	—		$	771		$	245		$	—		$	3,464

 

See accompanying notes.

 

6

 

EXCO RESOURCES, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited, in thousands)

 

		For the 28 Day Period From July 1 to July 28, 2003			For the 64 Day Period From July 29 to September 30, 2003			Three Months Ended September 30, 2004			For the 209 Day Period From January 1 to July 28, 2003			For the 64 Day Period From July 29 to September 30, 2003			Nine Months Ended September 30, 2004
		(Predecessor)			(Successor)			(Successor)			(Predecessor)			(Successor)			(Successor)
Net income (loss)		$	(7,035	)	$	3,726		$	(11,090	)	$	1,032		$	3,726		$	(17,400	)
Other comprehensive income:
Hedging activities:
Effective changes in fair value		13,873			—			—			14,701			—			—
Reclassification adjustments for settled contracts		(8,090		)	—			—			(14,540		)	—			—
Amortization of terminated contracts		(157		)	—			—			(1,763		)	—			—
Total hedging activities		5,626			—			—			(1,602		)	—			—
Foreign currency translation adjustment		(1,884		)	3,562			8,220			2,791			3,562			5,467
Unrealized gain (loss) on equity investments		454			(33		)	28			590			(33		)	26
Total comprehensive income (loss)		$	(2,839	)	$	7,255		$	(2,842	)	$	2,811		$	7,255		$	(11,907	)

 

See accompanying notes.

 

7

 

EXCO RESOURCES, INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2004

(Unaudited)

 

1.              The Merger

 

On July 29, 2003, pursuant to an Agreement and Plan of Merger, ER Acquisition, Inc., a Texas corporation and a wholly-owned subsidiary of EXCO Holdings Inc., a Delaware corporation, was merged into EXCO Resources, Inc. (EXCO, the Company, or Resources).  EXCO Holdings Inc. (Holdings or our parent) was formed by our chairman and chief executive officer, Douglas H. Miller, and his buying group for the purpose of entering into the merger agreement.  The holders of EXCO’s common stock, other than Holdings and its subsidiaries, received cash of $18.00 per share.  The buyout was funded with borrowings from EXCO’s existing credit facilities of approximately $53.6 million and approximately $172.0 million of equity.  The equity capital for Holdings was provided by:

 

• Cerberus Capital Management, L.P., or Cerberus, an investment management firm— $106.5 million in cash;

 

• Other institutional investors—$34.3 million in cash;

 

• Certain members of EXCO’s management—$10.5 million in cash and the contribution of EXCO shares; and

 

• Other institutional and other investors—$20.7 million in cash and the contribution of EXCO shares.

 

Upon completion of the merger transaction, EXCO’s common stock was delisted from trading on the NASDAQ National Market or any other exchange and EXCO’s common stock registration pursuant to Section 12(g)(4) of the Securities Exchange Act of 1934 was terminated. Accordingly, earnings per share data is not shown for any of the periods subsequent to July 28, 2003.

 

The total purchase price for EXCO was $353.5 million representing the purchase of all outstanding common stock and stock options including the amounts contributed to Holdings by management and key employees and other investors, and liabilities assumed as detailed below and has been allocated as follows (dollars in thousands):

 

8

 

 

(1) Represents deferred income taxes recorded at the date of the merger due to differences between the book basis and the tax basis of assets. For book purposes, we had a step-up in basis related to purchase accounting while our existing tax basis carried over.

 

As a result of the change in control, generally accepted accounting principles (GAAP) requires the acquisition by Holdings to be accounted for as a purchase transaction in accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations”.  GAAP requires the application of “push down accounting” in situations where the ownership of an entity has changed, meaning that the post-transaction financial statements of the acquired entity (i.e. EXCO) reflect the new basis of accounting in accordance with the Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 54.  Accordingly, the financial statements as of December 31, 2003 and for the 156 day period then ended reflect Holdings’ stepped up basis resulting from the acquisition that has been pushed down to us.  The aggregate purchase price has been allocated to the underlying assets and liabilities based upon the respective estimated fair values at July 29, 2003 (date of acquisition).  Carryover basis accounting applies for tax purposes.  All financial information presented prior to July 29, 2003 represents predecessor basis of accounting.

 

The purchase price allocation resulted in $51.1 million of goodwill, $24.2 million in the United States geographic operating segment and $26.9 million in the Canadian geographic operating segment.  None of the goodwill is deductible for income tax purposes.  Furthermore, in accordance with SFAS No. 142, “Goodwill and Intangible Assets”, goodwill is not amortized, but is tested for impairment on an annual basis, or more frequently as impairment indicators arise.  Impairment tests, which involve the use of estimates related to the fair market value of the business operations with which goodwill is associated, are performed annually at the end of our fourth quarter.  Losses, if any, resulting from impairment tests will be reflected in operating income in the statement of operations.  Changes in the balance of goodwill from the date of acquisition to December 31, 2003 are the result of foreign currency translation adjustments for associated Canadian goodwill.

 

See “Note 9.  Issuance of Senior Notes and the Acquisition of North Coast Energy, Inc.” for pro forma condensed consolidated statements of operations.

 

9

 

2.              Basis of Presentation

 

EXCO Resources, Inc., a Texas corporation, was formed in 1955.  Our operations consist primarily of acquiring interests in producing oil and natural gas properties located in the continental United States and Canada.  We also act as the operator of some of these properties and receive overhead reimbursement fees as a result.

 

The accompanying condensed consolidated balance sheets as of December 31, 2003 and September 30, 2004 and the results of operations, cash flows and comprehensive income for the 64 day period from July 29, 2003 to September 30, 2003 and the three and nine months ended September 30, 2004 are for EXCO and its subsidiaries and represent the stepped-up successor basis of accounting (New EXCO).

 

The accompanying condensed consolidated results of operations, cash flow and comprehensive income for the 28 day and 209 day periods ended July 28, 2003 are for EXCO and its subsidiaries and represent the predecessor basis of accounting (Old EXCO).  All inter-company transactions have been eliminated.

 

In management’s opinion, the accompanying unaudited consolidated financial statements contain all adjustments (consisting solely of normal recurring accruals) necessary to present fairly the financial position of EXCO Resources, Inc. as of December 31, 2003 and September 30, 2004, and the results of operations, cash flow and other comprehensive income for the 28 day and 209 day periods ended July 28, 2003, the 64 day period from July 29, 2003 to September 30, 2003 and the three and nine month periods ended September 30, 2004.

 

We have prepared the accompanying unaudited interim financial statements pursuant to the rules and regulations of the Securities and Exchange Commission.  We have omitted certain information and disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States pursuant to those rules and regulations, although we believe that the disclosures we have made are adequate to make the information presented not misleading.  You should read these unaudited interim financial statements in conjunction with our audited financial statements and notes included in the Prospectus for our senior notes exchange offer dated April 22, 2004.

 

The results of operations for the interim periods are not necessarily indicative of the results we expect for the full year.

 

Certain prior year amounts have been reclassified to conform to the current year presentation.

 

Stock Options

 

Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” defines a fair value based method of accounting for employee stock compensation plans, but allows for the continuation of the intrinsic value based method of accounting to measure compensation cost prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25).  For companies electing not to change their accounting, SFAS 123 requires pro forma disclosures of earnings and earnings per share as if the change in accounting provision of SFAS 123 has been adopted.

 

Old EXCO elected to continue to utilize the accounting method prescribed by APB 25, under which no compensation cost was recognized, and adopt the disclosure requirements of SFAS 123.  As a result, SFAS 123 had no effect on our results of operations for the 28 day and 209 day periods ended July 28, 2003.  Stock based compensation expense reflected in the table below for the 28 day and 209 day periods ended July 28, 2003, was a result of (1) the exercise of stock options at the time of our Going Private transaction; (2) options issued under Old EXCO’s 1998 Stock Option Plan that were issued subject to our shareholders’ approval; and, (3) and options that were issued to employees of Addison.

 

10

 

Had compensation costs for these plans been determined consistent with SFAS 123, Old EXCO’s net income and earnings per share (EPS) would have been adjusted to the following pro forma amounts:

 

				28 Day Period Ended July 28, 2003			209 Day Period Ended July 28, 2003
				(In thousands, except per share amounts)
Stock based compensation expense (net of taxes)		As Reported		$	6,416		$	6,969
		Pro Forma		$	1,223		$	2,578
Net income (loss)		As Reported		$	(7,035	)	$	1,032
		Pro Forma		$	(1,842	)	$	5,423
Basic EPS		As Reported		$	(0.58	)	$	(0.20	)
		Pro Forma		$	(0.15	)	$	0.35
Diluted EPS		As Reported		$	(0.58	)	$	(0.20	)
		Pro Forma		$	(0.15	)	$	0.22

 

Certain of our employees have been granted Holdings stock options under Holdings’ 2004 Long-Term Incentive Plan (the Holdings Plan).  The Holdings Plan provides for grants of stock options that can be exercised for Class A common shares of Holdings.  The stock options vest upon the earlier of specified events or three years from the date of grant and expire ten years after the date of grant.  Holdings has reserved 12,962,968 shares of its Class A common stock for issuance upon the exercise of stock options.  As of September 30, 2004, options for 8,801,354 shares of common stock have been granted by Holdings.

 

Effective with the grant of these options on June 3 and June 4, 2004, we have elected to continue to utilize the accounting method prescribed by APB 25 under which no compensation expense is required to be recognized upon the issuance of stock options to our employees as the exercise price of the option is equal to or higher than the fair value of the underlying common stock at the date of grant.

 

Under the minimum value method as prescribed under SFAS 123, no compensation expense was incurred during the three months or nine months ended September 30, 2004 from the granting of these stock options and as such, no pro forma disclosure is required. In addition, we anticipate no additional compensation expense during the remainder of 2004 from the grant of these options.

 

Foreign Currency Translation

 

Addison, our Canadian wholly-owned subsidiary, entered into a long-term note agreement with a U.S. subsidiary of EXCO in the amount of $98.8 million.  Addison used the proceeds of this borrowing to repay virtually all of its outstanding indebtedness under its Canadian credit agreement in April 2004.  The indebtedness is repayable in U.S. dollars on January 15, 2011. It bears interest at 7 ¼ % and contains similar terms and conditions to EXCO’s 7 ¼ % senior notes due January 15, 2011 (see Note 9 - “Issuance of Senior Notes and the Acquisition of North Coast Energy, Inc.”) or upon the sale of substantially all of its oil and gas properties.  Under the provisions of SFAS No. 52 — “Foreign Currency Translation”, Addison is required to recognize any foreign transaction gains or losses in its statement of operations when translating this liability from U.S. dollars to Canadian dollars. Gain or loss recognized by Addison is not eliminated when preparing EXCO’s consolidated statement of operations.  As a result, we have recorded non-cash foreign currency transaction gains of $5.6 million and $5.8 million during the three months and nine months ended September 30, 2004, respectively. These amounts are included in Other Income on the condensed consolidated statements of operations.

 

3.              Asset Retirement Obligations

 

Prior to 2003, Old EXCO provided for future site restoration costs on its Canadian oil and natural gas properties based upon management’s estimates.  The costs were being recognized over the remaining life of proved reserves by a charge to depreciation, depletion and amortization in the statement of operations with a related increase in the non-current deferred abandonment liability.  Actual expenditures for site restoration were charged to the deferred abandonment liability when incurred.  Old EXCO did not provide for site restoration on its U.S. properties as it estimated that salvage values would exceed the asset retirement costs.

 

In June 2001, the Financial Accounting Standards Board issued SFAS No. 143, “Accounting for Asset Retirement Obligations”.  The statement requires legal obligations associated with the retirement of long-lived assets to be recognized at their fair value at the time that the obligations are incurred.  Upon initial recognition of a liability, that cost should be capitalized as part of the related long-lived asset and allocated to expense over the useful life of the asset.  Old EXCO adopted the new rules on asset retirement obligations on January 1, 2003, for its U.S. and Canadian operations.  Application of the new rules resulted in an increase in net proved developed and undeveloped oil and natural gas properties of approximately $11.4 million, recognition of an asset retirement obligation liability of approximately $10.4 million, an increase in deferred income tax liability of approximately $690,000, and a cumulative effect of adoption that increased net income and stockholder’s equity by approximately $255,000.  The increase in net income resulting from the cumulative effect of the change in accounting increased basic earnings per share by $0.04 and diluted earnings per share by $0.02 for the 209 day period ended July 28, 2003.

 

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The following is a reconciliation of our asset retirement obligations as of September 30, 2003 and 2004 (in thousands of dollars):

 

 

		September 30,
		2003
		(Unaudited)
Deferred abandonment costs at beginning of year		$	2,176
Cumulative effect of change in accounting principle		10,433
Asset retirement obligations at January 1, 2003		12,609
Activity during the 209 day period from January 1, 2003 to July 28, 2003:
Liabilities incurred or assumed during period		239
Liabilities settled during period		(625		)
Accretion of discount		737
Effect of foreign currency conversions		786
Asset retirement obligation at July 28, 2003		13,746
Adjustment to liability due to purchase of EXCO by Holdings, timing, and other activity during the 64 day period from July 29, 2003 to September 30, 2003		1,998
Liabilities incurred during period		340
Liabilities settled during period		(148		)
Accretion of discount		201
Effect of foreign currency conversions		43
Asset retirement obligation, end of period		16,180
Less current portion		—
Long-term obligation		$	16,180

 

		September 30,
		2004
		(Unaudited)
Asset retirement obligations at January 1, 2004		$	17,742
Liabilities incurred or assumed during period		9,472
Liabilities settled during period		(2,449		)
Accretion of discount		1,258
Effect of foreign currency conversions		404
Asset retirement obligation, end of period		26,427
Less current portion		1,325
Long-term obligation		$	25,102

 

We have no assets that are legally restricted for purposes of settling asset retirement obligations.

 

4.              Earnings Per Share

 

SFAS No. 128, “Earnings per Share”, required Old EXCO to present two calculations of earnings per common share for the 28 day and 209 day periods ended July 28, 2003.  Basic earnings per common share equals net income less preferred stock dividends divided by weighted average common shares outstanding during the period.  Diluted earnings per common share equals net income divided by the sum of weighted average common shares outstanding during the period plus any dilutive common stock equivalents.  Common stock equivalents are shares assumed to be issued if (1) outstanding stock options or warrants were in-the-money and exercised, and (2) the outstanding 5% convertible preferred stock was converted to common stock.

 

Earnings per share subsequent to July 28, 2003 (after the going private transaction) are not presented since New EXCO is wholly-owned by Holdings, our parent.

 

		28 Day Period Ended July 28, 2003		209 Day Period Ended July 28, 2003
		(In thousands)
Weighted average number of basic shares outstanding		12,144		8,084
Effects of:
Employee and director stock options		—		535
Convertible preferred stock		—		4,363
Weighted average number of diluted shares outstanding		12,144		12,982

 

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5.                                      Oil and Natural Gas Properties

 

We have recorded oil and natural gas properties at cost using the full cost method of accounting.  Under the full cost method, all costs associated with the acquisition, exploration or development of oil and natural gas properties are capitalized as part of the full cost pool.

 

Unproved oil and natural gas properties are excluded from the calculation of depreciation, depletion and amortization until it is determined whether or not proved reserves can be assigned to such properties.  At December 31, 2003 and September 30, 2004, we had $9.2 million and $20.9 million, respectively, in unproved oil and natural gas properties.  We assess our unproved oil and natural gas properties on a quarterly basis.  During the nine months ended September 30, 2004, we reclassified $4.2 million from unproved oil and natural gas properties to proved oil and natural gas properties.

 

Depreciation, depletion and amortization of evaluated oil and natural gas properties is provided using the unit-of-production method based on total proved reserves, as determined by independent petroleum reservoir engineers.

 

Sales, dispositions and other oil and natural gas property retirements are accounted for as adjustments to the full cost pool, with no recognition of gain or loss unless the disposition would significantly alter the amortization rate.

 

At the end of each quarterly period, the unamortized cost of oil and natural gas properties, net of related deferred income taxes, is limited to the sum of the estimated future net revenues from proved properties using current period-end prices discounted at 10%, adjusted for related income tax effects.  This ceiling test calculation is done separately for the United States and Canadian full cost pools.

 

The calculation of the ceiling test is based upon estimates of proved reserves.  There are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting the future rates of production and plan of development.  The accuracy of any reserve estimate is a function of the quality of available data and of engineering and geological interpretation and judgment.  Results of drilling, testing and production subsequent to the date of the estimate may justify revision to the estimate.  Accordingly, reserve estimates are often different from the quantities of oil and natural gas that are ultimately recovered.

 

In September 2004, the SEC released SAB No. 106 concerning the application of SFAS No. 143 by oil and natural gas producing companies following the full cost method of accounting.  In SAB No. 106, the SEC addressed the impact of SFAS No. 143 on the ceiling test calculation and on the calculation of depreciation, depletion and amortization.  SAB No. 106 will be effective for us on January 1, 2005.

 

Prior to the issuance of SFAS No. 143, we included expected future cash flows related to the asset retirement obligations from certain properties in our ceiling test calculation.  Under SFAS 143, we must now initially capitalize asset retirement costs by increasing long-lived oil and natural gas assets by the same amount as the asset retirement liability before discount.  After adoption of SFAS No. 143, if we were to continue to calculate the full cost ceiling test by reducing expected future net revenues by the cash flows required to settle the asset retirement obligation, then the effect would be to “double-count” such costs in the ceiling test.  We do not believe the adoption of SAB No. 106 will have a significant impact on our ceiling test calculation for the year ending December 31, 2004.

 

6.                                      Geographic Operating Segment Information

 

The only industry segment in which we operate is the oil and natural gas exploration and production

 

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industry; however, we are organizationally structured along geographic operating segments.  We have reportable operations in the United States and Canada.  The following tables provide our interim geographic operating segment data.  Geographic operating segment income tax expenses have been determined based on expected effective tax rates for the various tax jurisdictions where we have oil and natural gas producing activities.

 

		United States			Canada			Corporate and Other			Total
		(In thousands)
For the 28 day period from July 1, 2003 to July 28, 2003:
Oil and natural gas sales		$	2,973		$	5,767		$	—		$	8,740
Other income (loss)		(2,387		)	—			2,755			368
		586			5,767			2,755			9,108
Production costs		1,462			925			—			2,387
Depreciation, depletion and amortization		767			1,109			—			1,876
Accretion expense		45			67			—			112
General and administrative		—			—			11,628			11,628
Interest		—			—			586			586
		2,274			2,101			12,214			16,589
Income (loss) before income taxes		(1,688		)	3,666			(9,459		)	(7,481		)
Income tax expense (benefit)		(574		)	1,513			(1,385		)	(446		)
Net income (loss)		$	(1,114	)	$	2,153		$	(8,074	)	$	(7,035	)
For the 209 day period from January 1, 2003 to July 28, 2003:
Oil and natural gas sales		$	22,403		$	39,013		$	—		$	61,416
Other income (loss)		(781		)	—			(252		)	(1,033		)
		21,622			39,013			(252		)	60,383
Production costs		11,380			8,413			—			19,793
Depreciation, depletion and amortization		5,483			6,539			—			12,022
Accretion expense		320			417			—			737
General and administrative		—			—			19,272			19,272
Interest		—			—			2,981			2,981
		17,183			15,369			22,253			54,805
Income (loss) before income taxes		4,439			23,644			(22,505		)	5,578
Income tax expense (benefit)		1,509			9,756			(6,464		)	4,801
Net income (loss)		$	2,930		$	13,888		$	(16,041	)	$	777

 

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