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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

 


 

FORM 10-Q

 


 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 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: 1-8847

 


 

TNP ENTERPRISES, INC.

(Exact name of registrant as specified in its charter)

 


 

Texas   75-1907501
(State of incorporation)   (I.R.S. employer identification number)

 

4100 International Plaza, P. O. Box 2943, Fort Worth, Texas 76113

(Address and zip code of principal executive offices)

 

Registrant’s telephone number, including area code 817-731-0099

 


 

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 Exchange Act Rule 12b-2).     Yes  ¨    No  x

 

TNP Enterprises, Inc. has no publicly traded shares of common stock outstanding.

 



Table of Contents

TNP Enterprises, Inc. And Subsidiaries

Quarterly Report on Form 10-Q for the period ended March 31, 2004

 

TABLE OF CONTENTS

 

    PART 1. FINANCIAL STATEMENTS

Item 1.

 

Financial Statements.

    
   

TNP Enterprises, Inc. (TNP) and Subsidiaries:

    
   

Consolidated Statements of Loss Three Month Periods Ended March 31, 2004 and 2003

   3
   

Consolidated Statements of Comprehensive Income (Loss) Three Month Periods Ended March 31, 2004 and 2003

   4
   

Consolidated Statements of Cash Flows Three Month Periods Ended March 31, 2004 and 2003

   5
   

Consolidated Balance Sheets March 31, 2004, and December 31, 2003

   6
   

Notes to Consolidated Interim Financial Statements

   7

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   15

Item 4.

 

Controls and Procedures

   23
    PART 2. OTHER INFORMATION

Item 1.

 

Legal Proceedings

   24

Item 6.

 

Exhibits and Reports on Form 8-K

   24
   

(a) Exhibit Index

   24
   

(b) Reports on Form 8-K

   24
   

Statement Regarding Forward Looking Information

   24

Signature page

   25

Certifications

   26

 

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Table of Contents

TNP ENTERPRISES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF LOSS

(Unaudited)

 

     Three Months Ended March 31,

 
     2004

    2003

 
     (In thousands)  

OPERATING REVENUES

   $ 162,150     $ 183,721  
    


 


OPERATING EXPENSES:

                

Purchased power

     79,037       136,969  

Other operating and maintenance

     47,181       52,062  

Depreciation

     7,433       7,123  

Taxes other than income taxes

     6,761       6,770  
    


 


Total operating expenses

     140,412       202,924  
    


 


OPERATING INCOME (LOSS)

     21,738       (19,203 )
    


 


INTEREST CHARGES, PREFERRED DIVIDENDS,

                

AND OTHER INCOME AND DEDUCTIONS:

                

Interest on long-term debt

     15,580       12,434  

Other interest and amortization of debt-related costs

     1,111       1,116  

Dividends on preferred stock and other

     5,907       —    

Other income and deductions, net

     (555 )     (369 )
    


 


Total

     22,043       13,181  
    


 


LOSS BEFORE INCOME TAXES

     (305 )     (32,384 )

Income taxes (benefits)

     1,942       (12,359 )
    


 


NET LOSS

     (2,247 )     (20,025 )

Dividends on preferred stock and other

     —         5,149  
    


 


LOSS APPLICABLE TO COMMON STOCK

   $ (2,247 )   $ (25,174 )
    


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

TNP ENTERPRISES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

 

     Three Months Ended March 31,

 
     2004

    2003

 
     (In thousands)  

NET LOSS

   $ (2,247 )   $ (20,025 )
    


 


Cash flow hedges, net of tax:

                

Gas hedge

     2,691       (3,024 )

Interest rate hedge, net of reclassification adjustment (Note 4)

     108       (645 )
    


 


Total cash flow hedges

     2,799       (3,669 )
    


 


COMPREHENSIVE INCOME (LOSS)

   $ 552     $ (23,694 )
    


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

TNP ENTERPRISES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

     Three Months Ended March 31,

 
     2004

    2003

 
     (In thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES:

                

Cash received from sales to customers

   $ 176,062     $ 163,935  

Purchased power costs paid

     (95,085 )     (96,141 )

Natural gas option premiums paid

     —         (18,652 )

Cash paid for payroll and to other suppliers

     (47,529 )     (44,580 )

Interest paid, net of amounts capitalized

     (7,566 )     (7,912 )

Income taxes refunded

     630       2,620  

Other taxes paid

     (12,948 )     (11,526 )

Other operating cash receipts and payments, net

     357       216  
    


 


NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES

     13,921       (12,040 )
    


 


CASH FLOWS FROM INVESTING ACTIVITIES:

                

Additions to utility plant and other investing activities

     (9,537 )     (9,035 )
    


 


NET CASH USED IN INVESTING ACTIVITIES

     (9,537 )     (9,035 )
    


 


CASH FLOWS FROM FINANCING ACTIVITIES:

                

Redemptions:

                

TNMP senior notes

     (5,000 )     —    

TNP senior secured credit facility

     (281 )     —    

TNP term loan

     —         (400 )

Borrowings from TNMP/First Choice credit facility - net

     —         14,000  

Financing costs

     (399 )     —    
    


 


NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES

     (5,680 )     13,600  
    


 


NET CHANGE IN CASH AND CASH EQUIVALENTS

     (1,296 )     (7,475 )

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     117,788       16,690  
    


 


CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 116,492     $ 9,215  
    


 


RECONCILIATION OF NET LOSS TO NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES:

                

Net loss

   $ (2,247 )   $ (20,025 )

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

                

Accrued dividends on preferred stock and other

     5,907       —    

Depreciation

     7,433       7,123  

Amortization of debt-related costs and other deferred charges

     1,155       1,041  

Allowance for funds used during construction

     (277 )     (220 )

Deferred income taxes

     2,859       (288 )

Investment tax credits

     (317 )     (159 )

Deferred purchased power and fuel costs

     34       921  

Cash flows impacted by changes in current assets and liabilities:

                

Accounts receivable

     23,084       (12,437 )

Accounts payable

     (19,430 )     43,108  

Accrued interest

     8,106       4,603  

Accrued taxes

     (5,606 )     (14,151 )

Changes in other current assets and liabilities

     (7,451 )     (17,227 )

Other, net

     671       (4,329 )
    


 


NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES

   $ 13,921     $ (12,040 )
    


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

TNP ENTERPRISES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

     March 31, 2004
(Unaudited)


    December 31,
2003


 
     (In thousands)  

ASSETS

                

CURRENT ASSETS:

                

Cash and cash equivalents

   $ 116,492     $ 117,788  

Special deposits

     2,524       2,520  

Accounts receivable

     71,903       94,987  

Materials and supplies, at lower of cost or market

     1,143       1,082  

Deferred purchased power and fuel costs

     220       135  

Accumulated deferred income taxes

     139       139  

Gas hedges

     9,542       6,237  

Other current assets

     7,923       2,640  
    


 


Total current assets

     209,886       225,528  
    


 


UTILITY PLANT:

                

Electric plant

     648,558       642,732  

Construction work in progress

     15,157       13,666  
    


 


Total

     663,715       656,398  

Less accumulated depreciation

     101,730       94,974  
    


 


Net utility plant

     561,985       561,424  
    


 


LONG-TERM AND OTHER ASSETS:

                

Other property and investments, at cost

     1,273       1,273  

Goodwill

     270,256       270,256  

Recoverable stranded costs

     298,651       298,651  

Regulatory tax assets

     1,906       1,685  

Deferred charges

     49,572       49,956  
    


 


Total long-term and other assets

     621,658       621,821  
    


 


     $ 1,393,529     $ 1,408,773  
    


 


LIABILITIES AND SHAREHOLDER’S EQUITY

                

CURRENT LIABILITIES:

                

Current maturities of long-term debt

   $ 1,125     $ 1,125  

Accounts payable

     35,424       57,379  

Accrued interest

     23,385       15,279  

Accrued taxes

     1,148       6,754  

Accrued payroll and benefits

     2,935       5,367  

Customers’ deposits

     6,662       6,342  

Other current liabilities

     5,694       5,689  
    


 


Total current liabilities

     76,373       97,935  
    


 


LONG-TERM AND OTHER LIABILITIES:

                

Deferred purchased power and fuel costs

     40,963       40,844  

Accumulated deferred income taxes

     141,137       136,882  

Accumulated deferred investment tax credits

     18,142       18,459  

Regulatory liability-accrued cost of removal

     38,895       38,218  

Deferred credits and other liabilities

     52,604       52,283  

Long-term debt, less current maturities

     804,244       809,439  

Redeemable cumulative preferred stock

     168,444       162,538  
    


 


Total long-term and other liabilities

     1,264,429       1,258,663  
    


 


COMMON SHAREHOLDER’S EQUITY

                

Common shareholder’s equity:

                

Common stock - no par value per share.

                

Authorized 1,000,000 shares; issued 100 shares

     100,000       100,000  

Accumulated deficit

     (50,740 )     (48,493 )

Accumulated other comprehensive income-gas hedge

     6,035       3,344  

Accumulated other comprehensive loss-other

     (2,568 )     (2,676 )
    


 


Total common shareholder’s equity

     52,727       52,175  
    


 


COMMITMENTS AND CONTINGENCIES (Note 8)

                
    


 


     $ 1,393,529     $ 1,408,773  
    


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

TNP Enterprises Inc. and Subsidiaries

Notes to Consolidated Interim Financial Statements

 

Note 1. Interim Financial Statements

 

The interim consolidated financial statements of TNP and subsidiaries are unaudited and contain all adjustments (consisting primarily of normal recurring accruals) necessary for a fair statement of the results for the interim periods presented. Results for interim periods are not necessarily indicative of results to be expected for a full year or for previously reported periods due in part to seasonal revenue fluctuations. It is suggested that these consolidated interim financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in TNP’s 2003 Annual Report on Form 10-K.

 

Prior period statements have been reclassified in order to be consistent with current period presentation. The reclassification had no effect on net income or common shareholder’s equity.

 

Note 2. Regulatory Matters

 

Texas

 

Retail Competition. As reported in TNP’s 2003 Annual Report on Form 10-K, the Texas electricity market has been open to retail competition since January 1, 2002. In accordance with Senate Bill 7, Texas-New Mexico Power Company (TNMP) provides transmission and distribution services at regulated rates to various retail electric providers that, in turn, provide retail electric service within TNMP’s Texas service area. First Choice Power (First Choice), TNMP’s affiliated retail electric provider, performs activities related to the sale of electricity to retail customers in Texas.

 

First Choice must offer customers that reside in TNMP’s service area, and whose loads are less than 1 megawatt, a regulated price, commonly called the price-to-beat. The price-to-beat will be offered through December 31, 2006, and First Choice cannot offer those customers any other rate before the loss of 40 percent of the energy consumed by its price-to-beat customers, or January 1, 2005, whichever occurs first. In January 2004, the Public Utility Commission of Texas (PUCT) approved a stipulation among TNMP and other parties, which found that First Choice had lost more than 40 percent of the energy consumed by its small commercial price-to-beat customers. As a result of PUCT’s action, First Choice may offer small commercial customers who reside in TNMP’s service area rates other than the price-to-beat. First Choice remains below the 40 percent loss threshold with respect to residential price-to-beat customers. Accordingly, First Choice continues to be prohibited from offering rates other than the price-to-beat to residential customers in TNMP’s service area.

 

In April 2004, the PUCT adopted several changes to customer protection rules that will be effective June 1, 2004. Of the changes, the rules related to disconnection for non-payment and the required amount of a customer deposit are expected to have the greatest impact on First Choice. The new rule for disconnection for non-payment states that if a customer does not make a payment or payment arrangement until after the final due date specified in the disconnect notice, the retail electric provider is allowed to disconnect the customer. The previous rule only allowed the retail electric provider to terminate service and drop the customer to the retail electric provider that was affiliated with the customer’s transmission and distribution service provider, or to the provider of last resort for non-payment. The new rule for the required amount of deposit states that the deposit shall not exceed the greater of one-fifth of the estimated annual billing or the sum of the next two month’s estimated billings. The previous rule stated that the deposit could not exceed the greater of one-sixth of the estimated annual billing or the sum of the next two month’s estimated billings.

 

Special Purpose Entity. On March 16, 2004, the PUCT issued its final order in Docket No. 29081, approving First Choice’s request to establish a bankruptcy remote Special Purpose Entity (SPE). The final order in this docket allowed the transfer of First Choice’s existing Retail Electric Provider certificate to the SPE and authorized the transfer of certain First Choice customers to the SPE. First Choice will make a filing with the PUCT in the second quarter of 2004 showing that it has complied with the terms of the final order. First Choice expects to establish the SPE on June 1, 2004, at which time the SPE will hold all customer contracts and wholesale power and gas contracts previously held by First Choice, with the exception of certain financial instruments held for hedging purposes.

 

2004 True-Up Proceeding. On January 22, 2004, TNMP filed its true-up proceeding with the PUCT. The PUCT assigned Docket No. 29206 to the true-up proceeding. The purpose of the true-up proceeding is to quantify and reconcile the amount of stranded costs that TNMP may recover from its transmission and distribution customers. The proceeding examined a number of issues, including the sale of TNP One that occurred in October 2002, the final fuel reconciliation and the clawback.

 

Based on TNMP’s true-up filing, the fair value of TNP One, less cost to sell, was approximately $117.6 million. The book value of TNP One as of December 31, 2001, was approximately $425.1 million.

 

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Table of Contents

In January 2004, the PUCT issued an order that disallowed $15.7 million of fuel and energy-related purchased power costs that TNMP incurred in 2000 and 2001. TNMP recorded the $10.1 million after-tax effect of the disallowance, and associated interest, in the fourth quarter of 2003. As a result of the PUCT decision, TNMP has an over-recovered balance of fuel and energy-related purchased power costs of $41.0 million as of March 31, 2004. The balance of fuel and energy-related purchased power costs resulting from the final fuel reconciliation is included in the true-up proceeding. TNMP’s over-recovered balance will reduce the amount of stranded costs TNMP would be entitled to recover from its transmission and distribution customers.

 

Senate Bill 7 includes a provision, commonly known as the clawback, that would require First Choice to credit TNMP the difference between the price-to-beat and the market price of electricity during the years 2002 and 2003. TNMP would then pass the credit received from First Choice to its transmission and distribution customers. The PUCT will confirm the amount of the clawback in the true-up proceeding. As indicated in the true-up filing, First Choice estimates that its clawback liability is $15.9 million.

 

In April 2004, the State Office of Administrative Hearings conducted hearings regarding the true-up proceeding. The schedule established for the true-up proceeding calls for a final order to be issued near the end of the second quarter of 2004. Following the true-up, the PUCT is required to conduct proceedings that will adjust TNMP’s rates to reflect the results of the true-up. However, TNMP is unable to predict the timing of this proceeding. In addition, the PUCT has the authority to reduce the price-to-beat fuel factor following the true-up proceeding, if conditions warrant.

 

Action taken by the PUCT in the true-up proceeding could affect the ultimate recovery of the amounts requested as recoverable stranded costs. PUCT action that limits the recovery of requested stranded costs could have a material impact on TNP’s and TNMP’s financial position and cash flows.

 

Cities Rate Review. During the fourth quarter of 2003, several Texas cities passed resolutions requiring TNMP to file certain financial information with the cities so that the cities may determine whether TNMP’s transmission and distribution rates are reasonable. TNMP filed information in response to the resolutions in November 2003 and has responded to additional requests for information from the cities. TNMP cannot predict what action the cities may take, or what effects any such action may have on its financial position, cash flows, or results of operation at this time.

 

Transmission Cost Recovery Factor. Due to changes in wholesale transmission rates, TNMP requested an update to its transmission cost recovery factor (TCRF). The TCRF is a non-bypassable transmission service charge paid by retail electric providers. On March 1, 2004, the PUCT approved a TCRF update in Docket No. 29295. TNMP estimates that this TCRF update will increase annual transmission revenue by $0.5 million.

 

New Mexico

 

Affiliated Guarantee. In October 2003, the New Mexico Public Regulation Commission (NMPRC) granted TNMP’s request for the authority to extend a portion of the guarantees that TNMP provided for certain power supply obligations of First Choice. TNMP expects that its authority to guarantee the power supply obligations of First Choice will terminate on June 1, 2004, when First Choice expects to have established a bankruptcy remote SPE under authorization granted by the PUCT in Docket No. 29081. The SPE will be established in connection with First Choice’s power supply agreement with Constellation.

 

Note 3. Accounting Developments

 

Employers’ Disclosures about Pensions and Other Postretirement Benefits

 

TNP has applied the revised disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits”. The revisions to SFAS 132 were issued in December 2003, and require additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The disclosures that are required by SFAS 132 are included in Note 5.

 

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Table of Contents

Financial Instruments with Characteristics of both Liabilities and Equity

 

TNP and TNMP adopted SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150), on December 31, 2003. SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 requires that an issuer classify a financial instrument that is within its scope as a liability or, in some circumstances, as an asset. As a result of the adoption of SFAS 150, TNP reclassified the balance of its redeemable cumulative preferred stock at December 31, 2003, as a liability. For the three months ended March 31, 2004, TNP classified dividends on preferred stock as interest expense. SFAS 150 does not permit the restatement of prior year expenses or balances of reclassified financial instruments. Accordingly, the dividends upon TNP’s redeemable preferred stock for periods prior to adoption have not been reclassified.

 

Accounting for Asset Retirement Obligations

 

TNP and TNMP adopted SFAS No. 143, “Accounting for Asset Retirement Obligations,” on January 1, 2003. The adoption had no impact on the financial position, results of operations, or cash flows of TNP and TNMP. As a result of the adoption of SFAS 143, TNP and TNMP identified costs recorded in accumulated depreciation related to inclusion of removal costs of utility plant in TNMP’s rates by the PUCT and NMPRC. Such costs do not arise from legal obligations. Rather, they represent long-standing regulatory policy to include charges for removal costs of utility plant in accumulated depreciation. Accordingly, TNMP has reclassified the estimated utility plant removal costs, which were $38.9 million and $38.2 million as of March 31, 2004 and December 31, 2003, respectively, from accumulated depreciation to a regulatory liability included in long-term and other liabilities on the balance sheet.

 

Note 4. Derivative Instruments, Hedging Activities, and Other Comprehensive Income

 

Normal Purchases and Sales. In the normal course of business, TNMP and First Choice enter into commodity contracts, which include “swing” components for additional purchases or sales of electricity, in order to meet customer requirements. The Financial Accounting Standards Board (FASB) has defined criteria by which option-type and forward contracts for electricity can qualify for the normal purchase and sales exception provided by SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS 149, “Amendments of Statement 133 on Derivative Instruments and Hedging Activities.” Based on the FASB’s guidance, the management of TNMP and First Choice has determined that their respective contracts for electricity qualify for the normal purchases and sales exception. Accordingly, TNMP and First Choice do not account for their respective electricity contracts as derivatives.

 

Hedging Activities

 

TNP, TNMP and First Choice may enter into agreements for derivative instruments, including options and swaps, to manage risks related to changes in interest rates and commodity prices. At the inception of any such transactions, TNP, TNMP, and First Choice document relationships between the hedging instruments and the items being hedged. The documentation includes the strategy that supports executing the specific transaction.

 

TNP Interest Rate Swaps. In October 2002, TNP executed a $70 million interest rate swap transaction designed to manage interest rate risk associated with the Senior Credit Facility. The swap will terminate in October 2004. Under the terms of the swap, TNP pays a fixed rate of approximately 2.5 percent and receives variable rates that are currently set at approximately 1.2 percent. As of March 31, 2004, the variable interest rate on the Senior Credit Facility was approximately 7.1 percent, including the effects of the swap.

 

The fair value of TNP’s swap as of March 31, 2004, was a liability of $0.7 million, which is recorded on its balance sheet in deferred credits and other liabilities.

 

The interest rate swap was designated as a cash flow hedge. The swap is highly effective in offsetting future cash flow volatility caused by changes in interest rates. For the three months ended March 31, 2004 and 2003, TNP recorded unrealized gains (losses), net of reclassification adjustments, associated with its interest rate swap in other comprehensive income as shown in the following table.

 

     Three Months Ended March 31, 2004

    Three Months Ended March 31, 2003

 
     Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


    Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


 
     (In thousands)  

Change in market value

   $ (271 )   $ 103     $ (168 )   $ (528 )   $ 201     $ (327 )

Reclassification adjustments

     238       (91 )     147       178       (68 )     110  
    


 


 


 


 


 


Other comprehensive income (loss)

   $ (33 )   $ 12     $ (21 )   $ (350 )   $ 133     $ (217 )
    


 


 


 


 


 


 

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Table of Contents

Over the next twelve months TNP anticipates that $0.4 million of unrealized after-tax losses will be reclassified from other comprehensive income to interest expense. The estimated amounts to be reclassified represent the earnings volatility that is avoided by using the interest rate swaps.

 

TNMP Interest Rate Hedges. In October 2002, TNMP executed two $75 million interest rate swap transactions designed to manage interest rate risk associated with the expired TNMP/First Choice Credit Facility. TNMP terminated the swaps in June 2003 in connection with the issuance of its $250 million of 6.125 percent Senior Notes due in 2008.

 

In May 2003, TNMP executed a $250 million Treasury rate lock transaction designed to manage interest rate risk associated with the issuance of its $250 million of 6.125 percent Senior Notes due in 2008. The rate lock effectively fixed the five-year Treasury yield upon which the yield of the Senior Notes was based at approximately 2.6 percent. TNMP paid $4.2 million upon the issuance of the Senior Notes in June 2003 to settle the rate lock. The cost of the rate lock was recorded in accumulated other comprehensive income and will be amortized to interest expense over the life of the Senior Notes.

 

The interest rate swaps and the Treasury rate lock were designated as cash flow hedges. The instruments were highly effective in offsetting future cash flow volatility caused by changes in interest rates. For the three months ended March 31, 2004 and 2003, TNMP recorded unrealized gains (losses), net of reclassification adjustments, associated with its interest rate swaps and Treasury rate lock in other comprehensive income as shown in the following table.

 

     Three Months Ended March 31, 2004

   Three Months Ended March 31, 2003

 
     Before-Tax
Amount


   Tax Benefit
(Expense)


    After-Tax
Amount


   Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


 
     (In thousands)  

Change in market value

   $  —      $  —       $  —      $ (1,067 )   $ 407     $ (660 )

Reclassification adjustments

     208      (79 )     129      374       (142 )     232  
    

  


 

  


 


 


Other comprehensive income (loss)

   $ 208    $ (79 )   $ 129    $ (693 )   $ 265     $ (428 )
    

  


 

  


 


 


 

TNMP displays cash flows from interest rate hedging transactions in the cash flow statement as cash flow from operations, in accordance with the provisions of SFAS No. 104, “Statement of Cash Flows-Net Reporting of Certain Cash Receipts and Cash Payments and Classification of Cash Flows from Hedging Transactions.”

 

Natural Gas Hedges. During 2003, First Choice purchased natural gas call options to mitigate commodity price risk associated with firm commitments to customers. As of December 31, 2003, all natural gas options purchased during 2003 had been liquidated due to the purchase of natural gas swaps, as discussed below.

 

The options were designated as cash flow hedges. The options were highly effective in offsetting future cash flow volatility caused by increases in natural gas prices. For the three months ended March 31, 2003, First Choice’s purchased power expense included pre-tax gains of $0.7 million ($0.4 million after tax) related to the exercise of natural gas call options.

 

Beginning in the third quarter of 2003, First Choice took advantage of favorable conditions in the natural gas market to enter into natural gas swaps, fixing the price of a portion of its power supply. The fair value of the natural gas swaps as of March 31, 2004, was an asset of $9.5 million, which is recorded on TNP’s balance sheet as a current asset. For the three months ended March 31, 2004, First Choice’s purchased power expense includes pre-tax gains of $2.1 million ($1.3 million after tax) related to the settlement of natural gas swaps.

 

In addition, First Choice recorded unrealized gains (losses), net of reclassification adjustments, associated with its natural gas hedges in other comprehensive income as shown in the following table.

 

     Three Months Ended March 31, 2004

    Three Months Ended March 31, 2003

 
     Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


    Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


 
     (In thousands)  

Change in market value

   $ 5,500     $ (2,096 )   $ 3,404     $ (4,914 )   $ 1,872     $ (3,042 )

Reclassification adjustments

     (1,152 )     439       (713 )     29       (11 )     18  
    


 


 


 


 


 


Other comprehensive income (loss)

   $ 4,348     $ (1,657 )   $ 2,691     $ (4,885 )   $ 1,861     $ (3,024 )
    


 


 


 


 


 


 

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Table of Contents

Over the next twelve months, First Choice estimates that a minimal amount of unrealized after-tax costs related to natural gas call options will be reclassified through other comprehensive income to purchased power expense. First Choice also estimates that $6.1 million of unrealized after-tax gains related to natural gas swaps will be reclassified through other comprehensive income to purchased power expense.

 

Note 5. Employee Benefit Plans

 

Pension and Postretirement Benefits Plans

 

TNP and its subsidiaries sponsor a defined benefit pension plan covering substantially all of its employees. Benefits are based on an employee’s years of service and compensation. TNP’s funding policy is to contribute the minimum amount required by federal funding standards. TNP provides an excess benefit plan for certain key personnel and retired employees whose benefits in the principal plan federal law restricts. TNP also sponsors a health care plan that provides postretirement medical and death benefits to retirees who satisfied minimum age and service requirements during employment.

 

The components of net periodic benefit cost of TNP’s employee benefit plans for the three months ended March 31, 2004 and 2003 are shown in the following table (amounts in thousands).

 

     Pension Benefits
Three Months Ended
March 31,


    Postretirement Benefits
Three Months Ended
March 31,


 
     2004

    2003

    2004

    2003

 

Components of net periodic benefit cost

                                

Service cost

   $ 554     $ 1,123     $ 106     $ 97  

Interest cost

     1,231       2,753       162       170  

Expected return on plan assets

     (1,532 )     (3,691 )     (89 )     (83 )

Settlements

     —         93       —         —    

Amortization of prior service cost

     5       10       —         —    

Recognized actuarial (gain) loss

     548       891       51       54  
    


 


 


 


Net periodic benefit cost

   $ 806     $ 1,179     $ 230     $ 238  
    


 


 


 


 

TNP reported expected 2004 contributions of $0.3 million to the pension plan and $1.0 million to the postretirement benefits plan in its 2003 Annual Report on Form 10-K. TNP does not expect that its 2004 contributions will vary significantly from the previously disclosed amounts.

 

Note 6. Related Party Transactions

 

In accordance with the SW Acquisition limited partnership agreement, TNP and Laurel Hill Capital Partners (Laurel Hill) are parties to a Management Services Agreement under which Laurel Hill provides certain management and financial advisory services to TNP. For each of the three-month periods ended March 31, 2004 and 2003, TNP paid Laurel Hill $0.3 million under the agreement.

 

TNP incurred fees of $0.3 million for the three months ended March 31, 2004, for advisory services by the original limited partners of SW Acquisition, pursuant to provisions of the SW Acquisition limited partnership agreement.

 

Note 7. Segment and Related Information

 

TNP has two reportable segments that reflect the separation of TNMP’s business according to the provisions of Senate Bill 7. The first segment includes TNMP’s regulated transmission and distribution business in Texas and its New Mexico operations, and the second includes the unregulated activities of First Choice relating to the sale of electricity to retail customers in Texas.

 

The following tables present information about revenues, profits, and assets of TNP’s reportable segments (in thousands). Amounts below in “All Other and Eliminations” include amounts related to the assets and operations of TNP One, which TNMP sold in October 2002.

 

-11-


Table of Contents
     Three Months Ended March 31, 2004

 
     Regulated
Transmission
and Distribution


    First
Choice


    All Other
and
Eliminations


    TNP
Consolidated


 

Income Statement Data

                                

Revenue from external customers

   $ 41,138     $ 121,012     $ —       $ 162,150  

Intercompany revenue

     20,516       —         (20,516 )     —    

Purchased power

     (17,446 )     (61,591 )     —         (79,037 )

Other direct costs

     (5,589 )     (37,500 )     20,085       (23,004 )

Depreciation expense

     (7,349 )     (82 )     (2 )     (7,433 )

Other operating expenses

     (17,562 )     (11,941 )     (1,435 )     (30,938 )
    


 


 


 


Operating income (loss)

     13,708       9,898       (1,868 )     21,738  

Other income and deductions, net

     474       43       38       555  

Interest charges

     (7,100 )     (75 )     (15,423 )     (22,598 )
    


 


 


 


Income (loss) before taxes

     7,082       9,866       (17,253 )     (305 )

Income taxes

     (2,338 )     (3,517 )     3,913       (1,942 )
    


 


 


 


Net income (loss)

   $ 4,744     $ 6,349     $ (13,340 )   $ (2,247 )
    


 


 


 


Cash Flow Data

                                

Cash received from customers

   $ 58,167     $ 141,201     $ (23,306 )   $ 176,062  

Purchased power costs paid

     (17,477 )     (77,608 )     —         (95,085 )

Cash paid for payroll and to other suppliers

     (14,783 )     (10,136 )     (1,959 )     (26,878 )

Transmission and distribution charges

     —         (43,538 )     22,887       (20,651 )

Interest and other taxes paid

     (16,866 )     (1,532 )     (2,116 )     (20,514 )

Intercompany dividends, income taxes refunded (paid), and other

     908       42       37       987  
    


 


 


 


Net cash provided by (used in) operations

     9,949       8,429       (4,457 )     13,921  
    


 


 


 


Net cash used in investing activities, primarily additions to utility plant

     (9,363 )     (174 )     —         (9,537 )
    


 


 


 


Borrowings from (repayments of) credit facilities

     —         —         (281 )     (281 )

Redemption of senior notes

     (5,000 )     —         —         (5,000 )

Intercompany borrowing

     —         —         —         —    

Other

     (295 )     —         (104 )     (399 )
    


 


 


 


Net cash provided by (used in) financing activities

   $ (5,295 )   $ —       $ (385 )   $ (5,680 )
    


 


 


 


Balance Sheet Data as of March 31, 2004

                                

Cash and cash equivalents

   $ 52,198     $ 53,299     $ 10,995     $ 116,492  

Accounts receivable

     28,066       52,530       (8,693 )     71,903  

Other current assets

     4,826       16,501       164       21,491  

Net utility plant

     559,088       2,880       17       561,985  

Goodwill

     —         —         270,256       270,256  

Recoverable stranded costs

     298,651       —         —         298,651  

Other property, regulatory tax assets and deferred charges

     30,667       3,819       18,265       52,751  
    


 


 


 


Total assets

   $ 973,496     $ 129,029     $ 291,004     $ 1,393,529  
    


 


 


 


Current maturities of long-term debt

   $ —       $ —       $ 1,125     $ 1,125  

Accounts payable

     7,971       35,722       (8,269 )     35,424  

Other current liabilities

     25,892       9,940       3,992       39,824  

Deferred purchased power and fuel costs

     40,963       —         —         40,963  

Accumulated deferred income taxes and investment tax credits

     173,086       —         (13,807 )     159,279  

Deferred credits

     23,124       15,926       13,554       52,604  

Regulatory liability-accrued cost of removal

     38,895       —         —         38,895  

Long-term debt, less current maturities

     418,713       —         385,531       804,244  

Redeemable cumulative preferred stock

     —         —         168,444       168,444  

Common shareholder’s equity

     244,852       67,441       (259,566 )     52,727  
    


 


 


 


Total liabilities and shareholder’s equity

   $ 973,496     $ 129,029     $ 291,004     $ 1,393,529  
    


 


 


 


 

-12-


Table of Contents
     Three Months Ended March 31, 2003

 
     Regulated
Transmission and
Distribution


    First
Choice


    All Other
and
Eliminations


    TNP
Consolidated


 

Income Statement Data

                                

Revenue from external customers

   $ 35,809     $ 147,912     $ —       $ 183,721  

Intercompany revenue

     25,556       —         (25,556 )     —    

Purchased power

     (17,036 )     (120,010 )     77       (136,969 )

Other direct costs

     (5,144 )     (48,005 )     25,159       (27,990 )

Depreciation expense

     (7,055 )     (67 )     (1 )     (7,123 )

Other operating expenses

     (16,602 )     (12,777 )     (1,463 )     (30,842 )
    


 


 


 


Operating income (loss)

     15,528       (32,947 )     (1,784 )     (19,203 )

Other income and deductions, net

     339       112       (82 )     369  

Interest charges

     (4,965 )     (304 )     (8,281 )     (13,550 )
    


 


 


 


Income (loss) before taxes

     10,902       (33,139 )     (10,147 )     (32,384 )

Income taxes

     (3,854 )     12,602       3,611       12,359  
    


 


 


 


Net income (loss)

   $ 7,048     $ (20,537 )   $ (6,536 )   $ (20,025 )
    


 


 


 


Cash Flow Data

                                

Cash received from customers

   $ 50,049     $ 133,919     $ (20,033 )   $ 163,935  

Purchased power costs paid

     (14,188 )     (82,194 )     241       (96,141 )

Natural gas option premiums paid

     —         (18,652 )     —         (18,652 )

Cash paid for payroll and to other suppliers

     (14,391 )     (12,715 )     (2,372 )     (29,478 )

Transmission and distribution charges

     —         (34,745 )     19,643       (15,102 )

Interest and other taxes paid

     (17,126 )     (1,502 )     (810 )     (19,438 )

Intercompany dividends, income taxes refunded (paid), and other

     1,100       1,516       220       2,836  
    


 


 


 


Net cash provided by (used in) operations

     5,444       (14,373 )     (3,111 )     (12,040 )
    


 


 


 


Net cash used in investing activities, primarily additions to utility plant

     (8,884 )     (151 )     —         (9,035 )
    


 


 


 


Borrowings from (repayments of) credit facilities

     14,000       —         (400 )     13,600  

Redemption of senior notes

     —         —         —         —    

Intercompany borrowing

     (10,757 )     10,757       —         —    

Other

     73       (73 )     —         —    
    


 


 


 


Net cash provided by (used in) financing activities

   $ 3,316     $ 10,684     $ (400 )   $ 13,600  
    


 


 


 


Balance Sheet Data as of March 31, 2003

                                

Cash and cash equivalents

   $ 158     $ 1,373     $ 7,684     $ 9,215  

Accounts receivable

     39,684       89,268       (22,131 )     106,821  

Other current assets

     2,388       18,064       (3,705 )     16,747  

Net utility plant

     541,769       2,841       23       544,633  

Goodwill

     —         —         270,256       270,256  

Recoverable stranded costs

     298,748       —         —         298,748  

Other property, regulatory tax assets and deferred charges

     21,988       523       25,120       47,631  
    


 


 


 


Total assets

   $ 904,735     $ 112,069     $ 277,247     $ 1,294,051  
    


 


 


 


Current maturities of long-term debt

   $ 185,000     $ —       $ 1,600     $ 186,600  

Accounts payable

     11,210       95,243       (21,358 )     85,095  

Other current liabilities

     41,352       905       (10,471 )     31,786  

Deferred purchased power and fuel costs

     23,770       —         —         23,770  

Accumulated deferred income taxes and investment tax credits

     167,905       (6,577 )     (10,058 )     151,270  

Regulatory liability - accrued cost of removal

     35,811       —         —         35,811  

Deferred credits

     25,957       12,725       15,380       54,062  

Long-term debt, less current maturities

     174,516       —         344,300       518,816  

Redeemable cumulative preferred stock

     —         —         145,601       145,601  

Common shareholder’s equity

     239,214       9,773       (187,747 )     61,240  
    


 


 


 


Total liabilities and shareholder’s equity

   $ 904,735     $ 112,069     $ 277,247     $ 1,294,051  
    


 


 


 


 

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Table of Contents

As of March 31, 2004, TNP has assigned approximately $178.7 million of goodwill to the Regulated Transmission and Distribution segment and approximately $91.6 million to First Choice.

 

Note 8. Commitments and Contingencies

 

Energy Supply

 

Constellation Agreement. As reported in the 2003 Annual Report on Form 10-K, First Choice and Constellation executed a new power supply agreement in October 2003 under which Constellation will supply First Choice the majority of its power requirements through the end of 2006. The new agreement included provisions that provided First Choice with sufficient credit for its Texas operations. As a result, First Choice has secured supply to serve all of its forecasted commitments to existing competitive customers for 2004 at fixed prices. In addition, First Choice has secured supply to serve all of its forecasted commitments to price-to-beat customers through September 2004 at fixed prices.

 

First Choice has implemented the new agreement with Constellation in three phases. Phase one began and ended in 2003. Phase two of the agreement began in December 2003 and is expected to end on June 1, 2004. On that date, First Choice expects to establish a bankruptcy remote SPE and transfer all of First Choice’s customers and receivables into the SPE, which will operate as a retail electric provider, as discussed in Note 2, and phase three will begin. First Choice took this action to comply with the PUCT order issued on March 16, 2004 that authorized the transfer of certain customers to the SPE.

 

The SPE will hold all customer contracts and wholesale power and gas contracts previously held by First Choice, with the exception of certain financial instruments held for hedging purposes. Constellation will receive a lien against billed and unbilled receivables and variable amounts of cash of the SPE to cover settlement exposure and mark-to-market exposure rather than requiring First Choice to post alternate collateral for purchased power supply. However, if a dramatic change in electricity or gas forward prices creates an increase in Constellation’s credit exposure to First Choice beyond a limit based on cash and accounts receivable, First Choice will be constrained in its ability to sign up additional customers until that imbalance is corrected. Constellation will also have a lien against the customer contracts and equity of the SPE. The lien will provide the SPE with enough credit to purchase power without the need to deposit cash collateral with Constellation and will release TNMP from its $25 million guarantee of certain power supply obligations of First Choice upon establishment of the SPE.

 

Phase three will continue until the expiration of the agreement on December 31, 2006. First Choice may terminate the agreement upon ninety days prior notice to Constellation, for any reason. In the event of termination, the security interest in SPE’s accounts receivable granted to Constellation would remain in effect until the SPE’s obligations are paid in full, and until the power supply agreements with Constellation are terminated. Alternatively the SPE can provide Constellation with alternate collateral. Provisions of the power supply agreements that by their terms survive termination would expire on their original expiration dates.

 

Other

 

TNP and TNMP are involved in various claims and other legal proceedings arising in the ordinary course of business. In the opinion of management, the dispositions of these matters will not have a material adverse effect on TNP’s and TNMP’s consolidated financial condition or results of operations.

 

-14-


Table of Contents

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A).

 

Competitive Conditions

 

First Choice Customer Operations

 

As discussed in Note 2, the Texas electricity market has been open to retail competition since January 1, 2002. First Choice has addressed, and continues to address, a number of issues related to the development of retail competition.

 

Customer Retention and Acquisition. At March 31, 2004, First Choice served approximately 173,000 customers at price-to-beat rates and approximately 59,000 customers at competitive rates. At March 31, 2003, First Choice served approximately 186,000 and 55,000 price-to-beat and competitive customers, respectively. In response to the factors discussed in Bad Debt and Delinquency, below, First Choice is not actively pursuing mass market customers. Mass market customers who choose First Choice as their retail electric provider are required to make a deposit before First Choice begins service.

 

Bad Debt and Delinquency. Under current PUCT rules, First Choice has the right to disconnect customers that reside in TNMP’s transmission and distribution service territory for nonpayment. However, First Choice is prohibited from disconnecting customers who reside outside TNMP’s transmission and distribution service territory for nonpayment, but may transfer such a customer to the affiliated retail electric provider of the transmission and distribution service provider that serves the transferred customer.

 

The current structure described above limits First Choice’s collection activities, and affects both bad debt expense and the level of delinquent accounts receivable. Bad debt expense as a percentage of operating revenues for First Choice was approximately 2.1 percent at March 31, 2004, compared with 1.4 percent at March 31, 2003. On average, delinquent accounts receivable were approximately 9.0 percent of monthly operating revenue for the three months ended March 31, 2004, compared with a 7.4 percent delinquency rate for the three months ended March 31, 2003.

 

As discussed in Note 2, the PUCT is implementing changes to the current customer protection rules. As a result, First Choice will have the right to disconnect customers that reside both inside and outside TNMP’s transmission and distribution service territory for nonpayment starting on June 1, 2004. First Choice expects that both its bad debt and delinquency rates will decrease due to the implementation of these new customer protection rules.

 

First Choice Energy Supply

 

Strategy for mitigating fluctuation in costs of energy supply. First Choice’s basic strategy is to minimize its exposure to fluctuations in market energy prices by matching fixed price sales contracts with fixed price supply. In addition, First Choice can use its ability to change the price-to-beat fuel factor to mitigate fluctuations in the cost of its price-to-beat energy supply and use various financial instruments to hedge against the risk of adverse changes in natural gas prices.

 

Phase Three of Constellation Power Supply Agreement. As reported in the 2003 Annual Report on Form 10-K, First Choice and Constellation executed a new power supply agreement in October 2003 under which Constellation will supply First Choice the majority of its power requirements through the end of 2006. The new agreement included provisions that provided First Choice with sufficient credit for its Texas operations. As a result, First Choice has secured supply to serve all of its forecasted commitments to existing competitive customers for 2004 at fixed prices. In addition, First Choice has secured supply to serve all of its forecasted commitments to price-to-beat customers through September 2004 at fixed prices.

 

First Choice has implemented the new agreement with Constellation in three phases. Phase one began and ended in 2003. Phase two of the agreement began in December 2003 and is expected to end on June 1, 2004. On that date, First Choice expects to establish a bankruptcy remote SPE and transfer all of First Choice’s customers and receivables into the SPE, which will operate as a retail electric provider, as discussed in Note 2, and phase three will begin. First Choice took this action to comply with the PUCT order issued on March 16, 2004 that authorized the transfer of certain customers to the SPE.

 

-15-


Table of Contents

The SPE will hold all customer contracts and wholesale power and gas contracts previously held by First Choice, with the exception of certain financial instruments held for hedging purposes. Constellation will receive a lien against billed and unbilled receivables and variable amounts of cash of the SPE to cover settlement exposure and mark-to-market exposure rather than requiring First Choice to post alternate collateral for purchased power supply. However, if a dramatic change in electricity or gas forward prices creates an increase in Constellation’s credit exposure to First Choice beyond a limit based on cash and accounts receivable, First Choice will be constrained in its ability to sign up additional customers until that imbalance is corrected. Constellation will also have a lien against the customer contracts and equity of the SPE. The lien will provide the SPE with enough credit to purchase power without the need to deposit cash collateral with Constellation and will release TNMP from its $25 million guarantee of certain power supply obligations of First Choice upon establishment of the SPE.

 

Load Forecasting. First Choice’s load fluctuates continuously due to among other things, customer additions and losses, changes in customers’ usage, severe or unexpected weather and timing of customer switching. First Choice continually monitors and revises its load forecast to account for changing customer loads (both price-to-beat and competitive). First Choice develops short-term load forecasts to identify short-term load surpluses and shortages, and to insure that hedges are in place to cover expected sales. To the extent these short-term load forecasts identify shortages, First Choice covers shortages through short-term power purchases. First Choice may cover off-peak shortages through purchases on the Electric Reliability Council of Texas (ERCOT) balancing market where off-peak prices are generally lower than can be contracted through short-term purchases.

 

The restructured power supply agreement with Constellation resulted in Constellation assuming the risks related to changes in expected customers’ usage and weather-related risks. First Choice retained the risks associated with customer attrition.

 

TNMP

 

TNMP provides transmission and distribution services within TNMP’s Texas service area at regulated rates to various retail electric providers that, in turn, provide retail electric service. As of March 31, 2004, 34 retail electric providers served customers that receive transmission and distribution services from TNMP. First Choice provided electric service to customers that accounted for approximately 45 percent of the energy delivered by TNMP for the quarter ended March 31, 2004. TNMP’s next largest customer was a non-affiliated retail electric provider that served customers that accounted for approximately 25 percent of the energy delivered by TNMP during the quarter ended March 31, 2004.

 

Critical Accounting Policies

 

TNP is required to use estimates in order to prepare the consolidated interim financial statements in accordance with generally accepted accounting principles. Those estimates include accruals for estimated revenues for electricity delivered from the latest billing date to the end of the accounting period and estimated purchased power expenses incurred but not billed at the end of the accounting period. The use of these estimates is customary in the electric utility industry. Estimated revenues and purchased power expenses are adjusted to the actual amounts billed or incurred in the following month.

 

In addition, purchased power expenses are subject to adjustment due to revisions that ERCOT may make to the metered load of First Choice during ERCOT’s settlement process. First Choice has recorded an estimate of ERCOT’s resettlement adjustment for the year ended December 31, 2003. Upon receipt of the final ERCOT true-up adjustment, First Choice will adjust the currently recorded estimate. The amount of this adjustment could be significant to the results of operations of First Choice.

 

TNP also employs certain critical accounting policies that require use of judgments and assumptions that are subject to uncertainty. The amounts reported in the consolidated interim financial statements that are related to those critical accounting policies could be different if either different judgments were made or different assumptions were used. Those critical accounting policies are discussed below.

 

Goodwill and Intangible Assets. TNP has goodwill related to the Merger that had a carrying value of $270.3 million as of March 31, 2004. As discussed in Note 7, TNP has apportioned the carrying value of the goodwill between its Regulated Transmission and Distribution segment and First Choice. As of March 31, 2004, TNP had assigned approximately $178.7 million of goodwill to the Regulated Transmission and Distribution segment and approximately $91.6 million to First Choice.

 

SFAS No. 142, “Goodwill and Other Intangible Assets” (SFAS 142) requires TNP to test goodwill for impairment at least annually and more frequently when indicators of impairment exist. TNP performed its annual goodwill impairment test as of December 31, 2003, and concluded that the fair value of the goodwill related to the Merger exceeded its carrying value.

 

-16-


Table of Contents

To determine the fair value of the goodwill, TNP estimated the fair value of the Regulated Transmission and Distribution and First Choice segments. TNP’s estimate was based on the present value of the projected cash flows of each segment. Projected cash flows for the segments were derived from TNP’s five-year financial forecast.

 

The five-year forecast is subject to a number of estimates, including projections of customer growth and margins at First Choice and the effects of regulation on both First Choice and TNMP. To the extent the assumptions are not achieved, or cannot be sustained, future assumptions may require modification, and such modifications would affect the estimates of expected cash flows contained in TNP’s annual goodwill impairment test. Accordingly, TNP’s conclusion regarding the fair value of goodwill would be affected by changes in the five-year financial forecast.

 

Accounting for Derivatives – Normal Purchases and Sales. In the normal course of business, TNMP and First Choice enter into commodity contracts, which include “swing” components for additional purchases or sales of electricity, in order to meet customer requirements. In most circumstances, such contracts would be defined as derivatives under SFAS 133. However, the FASB has defined criteria by which option-type and forward contracts for electricity could qualify for the normal purchase and sales exception provided by SFAS 133, as amended by SFAS 149. Based on the FASB’s guidance, the management of TNMP and First Choice has determined that their respective contracts for electricity qualify for the normal purchases and sales exception. Accordingly, TNMP and First Choice do not account for their respective electricity contracts as derivatives.

 

If TNMP and First Choice were required to account for their respective electricity contracts as derivatives, the fair values of the contracts would be recorded on the balance sheet as assets or liabilities. Changes in the fair values of the contracts would be recognized in earnings.

 

Recoverable Stranded Costs – Sale of TNP One. TNMP sold TNP One in October 2002. Based on TNMP’s true-up filing, as discussed in Note 2, the fair value of TNP One, less cost to sell, was approximately $117.6 million. The book value included in the true-up filing was approximately $425.1 million. TNMP believes that the difference between the fair value of TNP One, net of selling costs, and its book value is recoverable from TNMP’s Texas transmission and distribution customers under the provisions of Senate Bill 7.

 

Under the provisions of Senate Bill 7, the amount and manner of stranded cost recovery is subject to review and approval by the PUCT as part of the true-up proceeding. In addition to the sale of TNP One, other issues will affect the amount of stranded costs that TNMP will recover from its customers. Those other issues include, among others, the final fuel reconciliation, as discussed in Note 2.

 

Action taken by the PUCT in the true-up proceeding could affect the ultimate recovery of the amounts requested as recoverable stranded costs. PUCT action that limits the recovery of requested stranded costs could have a material impact on TNP’s and TNMP’s financial position and cash flows.

 

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Results of Operations

 

The following discussion should be read in conjunction with the related consolidated interim financial statements and notes.

 

Overall Results

 

TNP had a loss applicable to common stock of $2.2 million for the quarter ended March 31, 2004, compared with a loss applicable to common stock of $25.2 million for the quarter ended March 31, 2003. The changes in TNP’s earnings for the quarter ended March 31, 2004 are attributable to the factors listed below (in millions):

 

     Earnings
Increase(Decrease)


 
     Three Months
Ended March 31,
2004 v. 2003


 

Change in First Choice net income (loss)

   $ 26.9  

Change in TNMP net income

     (2.3 )

TNP Preferred stock dividends

     (0.7 )

All other and intercompany eliminations

     (0.9 )
    


TNP consolidated earnings

   $ 23.0  
    


 

First Choice Results

 

First Choice had net income of $6.4 million for the quarter ended March 31, 2004, compared with a net loss of $20.5 million for the quarter ended March 31, 2003. The changes in First Choice’s earnings for the quarter ended March 31, 2004 are attributable to the factors listed below (in millions):

 

     Earnings
Increase(Decrease)


 
     Three Months
Ended March 31,
2004 v. 2003


 

Changes in gross profit

   $ 42.0  

Other operating and maintenance

     0.7  

All other (including income tax effects on the items above)

     (15.8 )
    


Change in First Choice net income (loss)

   $ 26.9  
    


 

First Choice Gross Profit

 

The following table summarizes the components of First Choice gross profit (in thousands).

 

     Three Months Ended March 31,

 
     2004

   2003

    Increase
(Decrease)


 

Operating revenues

   $ 121,012    $ 147,912     $ (26,900 )

Transmission and distribution costs

     37,500      48,005       (10,505 )
    

  


 


Operating revenues, net of transmission and distribution costs

     83,512      99,907       (16,395 )

Purchased power

     61,591      120,010       (58,419 )
    

  


 


Gross profit

   $ 21,921    $ (20,103 )   $ 42,024  
    

  


 


 

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Transmission and distribution costs are included in the “Other operating and maintenance” line of TNP’s consolidated income statement. The following table summarizes the components of the change in First Choice’s gross profit for the three months ended March 31, 2004, compared with the same period in 2003 (in thousands).

 

     Increase (Decrease)

 
     Three Months
Ended March 31,
2004 v. 2003


 

Price variances

        

Changes in price-to-beat rates, primarily fuel factor increases

   $ 2,390  

Changes in competitive rates

     5,521  

Decreased purchased power expenses attributable to lower prices

     16,166  

Quantity variances

        

Decreased sales to competitive customers, net of transmission and distribution charges

     (12,256 )

Decreased purchased power expenses attributable to lower sales to competitive customers

     19,285  

Decreased sales to price-to-beat customers, net of transmission and distribution charges

     (11,888 )

Decreased purchased power expenses attributable to lower sales to price-to-beat customers

     12,890  

Prior period adjustments to purchased power expense

     10,078  

All other

     (162 )
    


Gross profit

   $ 42,024  
    


 

Gross profit for the three months ended March 31, 2004, increased $42.0 million compared with the corresponding 2003 period. The increase in the quarter resulted from lower purchased power expenses and was partially offset by decreased revenues from competitive and price-to-beat customers.

 

Revenues from price-to-beat customers for the first quarter, net of transmission and distribution charges, decreased $9.5 million compared to the same period in 2003. The decrease was caused by milder weather conditions in the first quarter of 2004 compared to the first quarter of 2003 and a decrease in the number of price-to-beat customers, partially offset by increases in the price-to-beat fuel factor that were implemented during 2003.

 

Revenues from competitive customers, net of transmission and distribution charges, decreased $6.7 million for the quarter ended March 31, 2004, compared with the quarter ended March 31, 2003. Decreased sales resulting from milder weather in the first quarter of 2004 compared to the first quarter of 2003 and the departure of unprofitable customers were primarily responsible for the decrease in revenue. The decrease in revenue was partially offset by increases in rates of $5.5 million. Beginning in 2003, First Choice charged competitive customers higher rates to offset increasing natural gas prices.

 

Retail electric providers such as First Choice include a transmission and distribution charge in the prices they charge their customers for electric service. The transmission and distribution charge is regulated by the PUCT and is designed to allow the utility that provides transmission and distribution services within a specific service area, referred to as the transmission and distribution service provider, to recover its cost of service. During the three months ended March 31, 2004, First Choice billed its customers and incurred transmission and distribution costs related to sales to price-to-beat and competitive customers of $37.5 million, compared with $48.0 million for the three months ended March 31, 2003. As noted above, the decreases reflect a decrease in the number of price-to-beat and competitive customers along with lower weather-related sales in the first three months of 2004 compared to the first three months of 2003.

 

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Purchased power expenses decreased $58.4 million for the three months ended March 31, 2004 compared with the amount incurred in the same period in 2003. Lower prices accounted for $16.2 million of the decrease. Natural gas prices began to rise late in 2002 and spiked in March 2003. First Choice responded to the increases by purchasing natural gas options to mitigate the risk of increasing natural gas prices. Since that time, First Choice has restructured its purchase power agreement with Constellation. The new agreement included provisions that provided First Choice with sufficient credit for its Texas operations, giving First Choice the ability to purchase natural gas at fixed prices, thereby locking in the cost of its energy supply. An additional $32.2 million of the decrease resulted from a decrease in sales during the first quarter of 2004 compared with the first quarter of 2003 as discussed above. Purchased power was also reduced by $10.1 million attributable to adjustments to purchased power expense recorded in prior periods. In the first quarter of 2004, First Choice recorded a $5.0 million reduction in purchased power expenses related to its estimate of ERCOT’s resettlement adjustment for the year ended December 31, 2003. Purchased power expenses in the first quarter of 2003 included additional expenses associated with a true-up of fourth quarter 2002 purchased power costs of $5.1 million.

 

Other Operating and Maintenance

 

Other operating and maintenance expenses for the first quarter of 2004 decreased $0.7 million compared with the same period in 2003. The decrease resulted primarily from lower marketing expenses.

 

TNMP Results

 

TNMP had income applicable to common stock of $4.7 million for the quarter ended March 31, 2004, compared with income applicable to common stock of $7.0 million for the quarter ended March 31, 2003. The changes in TNMP’s earnings for the quarter ended March 31, 2004 are attributable to the factors listed below (in millions):

 

     Earnings
Increase(Decrease)


 
     Three Months
Ended March 31,
2004 v. 2003


 

Changes in gross profit

   $ (0.6 )

Other operating and maintenance

     (0.7 )

Interest charges

     (2.1 )

All other (including income tax effects on the items above)

     1.1  
    


TNMP consolidated earnings

   $ (2.3 )
    


 

TNMP Gross Profit

 

The following table summarizes the components of TNMP gross profit (in thousands).

 

    

Three Months Ended

March 31, 2004


 
     2004

   2003

   Increase
(Decrease)


 

Operating revenues

   $ 61,654    $ 61,365    $ 289  

Purchased power

     17,446      16,959      487  

Transmission expense

     5,589      5,144      445  
    

  

  


Gross profit

   $ 38,619    $ 39,262    $ (643 )
    

  

  


 

Transmission expense is included in the “Other operating and maintenance” line of TNP’s consolidated income statement.

 

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The following table summarizes the components of the change in TNMP’s gross profit for the three months ended March 31, 2004, compared with the same period in 2003 (in thousands).

 

     Increase/(Decrease)

 
     Three Months
Ended March 31,
2004 v. 2003


 

Weather related

   $ (1,924 )

Electric service revenues

     1,184  

Customer growth

     607  

All other

     (510 )
    


Gross profit

   $ (643 )
    


 

Gross profit for the three months ended March 31, 2004, decreased $0.6 million, or 1.6 percent compared with the corresponding 2003 period. The overall decrease is driven by a $1.9 million decrease in revenue due to lower sales resulting from milder weather. Partially offsetting these reductions were increases in revenues of $1.2 million due to the timing of billings for electric property rent, and $0.6 million associated with growth in customers.

 

Purchased power expenses increased by $0.5 million for the three months ended March 31, 2004 compared with the amount incurred in the same period in 2003. The increase did not affect gross profit because all of TNMP’s purchased power expense is incurred in New Mexico, where TNMP recovers all purchased power costs through the fuel and purchased power adjustment clause authorized by the NMPRC.

 

Operating Expenses

 

For the three months ended March 31, 2004, TNMP incurred operating expenses of $47.9 million, an increase of $2.1 million from the amount incurred during the corresponding period of 2003. Operating expenses include purchased power and transmission expense. Those expenses increased $0.9 million for the three months ended March 31, 2004, compared with the same period in 2003.

 

The details in the changes of purchased power and transmission expense are discussed above in “Gross Profit.” The remaining components of the changes in operating expenses are discussed below.

 

Other Operating and Maintenance

 

Other operating and maintenance expenses for the first quarter of 2004 increased $0.7 million compared with the same period in 2003. The increase is due to legal expenses incurred in connection with the true-up proceeding discussed in Note 2 and higher tree trimming expenses.

 

Interest Expenses

 

Interest expenses increased $2.1 million for the three months ended March 31, 2004, compared to the same period in 2003. The increase reflects interest on TNMP’s issuance of $250 million of 6.125 percent Senior Notes in June 2003.

 

Financial Condition

 

TNP Liquidity

 

TNP’s main sources of liquidity, and its ability to service its debt, depend primarily on the earnings of its subsidiaries, TNMP and First Choice. TNP receives distributions of those earnings in the form of cash dividends, as well as payments from its subsidiaries under a tax sharing agreement.

 

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For the three months ended March 31, 2004, TNP’s cash flow from operations was $26.0 million higher than in the three months ended March 31, 2003. The factors causing the increase in cash flow from operations are summarized in the following table (in millions).

 

     Cash Flow
Increase(Decrease)


 
     Three Months
Ended March 31,
2004 v. 2003


 

Cash paid in 2003 for natural gas options

   $ 18.6  

Increased cash flow from sales, net of purchased power payments

     13.2  

Increased cash paid to suppliers

     (2.9 )

Income taxes refunded

     (2.0 )

All other

     (0.9 )
    


TNP consolidated cash flow from operations

   $ 26.0  
    


 

In the first half of 2003, First Choice purchased natural gas options as part of a strategy to mitigate the risk of increasing natural gas prices. The purchases of natural gas options ended in the second half of 2003. Cash flow from sales net of purchased power payments increased due to increases in the price-to-beat fuel factor along with lower natural gas prices. The increased payments to suppliers are primarily attributable to increased transmission and distribution charges. Income tax refunds decreased due to amounts received from prior year amended returns.

 

Management believes that dividends from its subsidiaries, payments under the tax sharing agreement, and cash on hand should be sufficient to meet TNP’s working capital requirements at least through the end of 2005.

 

First Choice Liquidity

 

First Choice Liquidity. As reported in 2003 Annual Report on Form 10-K, First Choice and Constellation executed a new power supply agreement in October 2003 under which Constellation will supply First Choice the majority of its power requirements through the end of 2006.

 

First Choice has implemented the new agreement with Constellation in three phases. Phase one began and ended in 2003. Phase two of the agreement began in December 2003 and is expected to end on June 1, 2004. On that date, First Choice expects to establish a bankruptcy remote SPE and transfer all of First Choice’s customers and receivables into the SPE, which will operate as a retail electric provider, as discussed in Note 2, and phase three will begin. First Choice took this action to comply with the PUCT order issued on March 16, 2004 that authorized the transfer of certain customers to the SPE.

 

The SPE will hold all customer contracts and wholesale power and gas contracts previously held by First Choice, with the exception of certain financial instruments held for hedging purposes. Constellation will receive a lien against billed and unbilled receivables and variable amounts of cash of the SPE to cover settlement exposure and mark-to-market exposure rather than requiring First Choice to post alternate collateral for purchased power supply. However, if a dramatic change in electricity or gas forward prices creates an increase in Constellation’s credit exposure to First Choice beyond a limit based on cash and accounts receivable, First Choice will be constrained in its ability to sign up additional customers until that imbalance is corrected. Constellation will also have a lien against the customer contracts and equity of the SPE. The lien will provide the SPE with enough credit to purchase power without the need to deposit cash collateral with Constellation and will release TNMP from its $25 million guarantee of certain power supply obligations of First Choice upon establishment of the SPE.

 

Phase three will continue until the expiration of the agreement on December 31, 2006. First Choice may terminate the agreement upon ninety days prior notice to Constellation, for any reason. In the event of termination, the security interest in SPE’s accounts receivable granted to Constellation would remain in effect until the SPE’s obligations are paid in full, and until the power supply agreements with Constellation are terminated. Alternatively the SPE can provide Constellation with alternate collateral. Provisions of the power supply agreements that by their terms survive termination would expire on their original expiration dates.

 

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TNMP Liquidity

 

Affiliated Guarantee. In October 2003, the NMPRC granted TNMP’s request for the authority to extend a portion of the guarantees that TNMP provided for certain power supply obligations of First Choice. TNMP expects that its authority to guarantee the power supply obligations of First Choice will terminate on June 1, 2004, when First Choice expects to have established a bankruptcy remote SPE under authorization granted by the PUCT in Docket No. 29081. The SPE will be established in connection with First Choice’s power supply agreement with Constellation.

 

TNMP 6.25 Percent Senior Notes Due in 2009. In February 2004, TNMP repurchased $5 million of the $175 million of 6.25 percent Senior Notes due in 2009. TNMP repurchased an additional $2.3 million of the Senior Notes in April 2004.

 

TNMP believes that cash flow from its operations and cash on hand will be sufficient to meet its working capital requirements at least through the end of 2005, without the need for additional bank financing. TNMP’s cash balance as of March 31, 2004, was approximately $52 million.

 

Item 4. Controls and Procedures.

 

As of March 31, 2004, the Chief Executive Officer and Chief Financial Officer of TNP evaluated the effectiveness of the companies’ disclosure controls and procedures pursuant to applicable Exchange Act Rules. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer of TNP have each concluded that these disclosure controls and procedures are effective in timely alerting them to material information relating to their respective companies (including their consolidated subsidiaries) that is required to be included in TNP’s periodic SEC filings.

 

There have been no significant changes in TNP’s internal controls or in other factors that could significantly affect these controls during the three months ended to March 31, 2004.

 

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PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

 

See Notes 2 and 8 for information regarding additional regulatory and legal matters.

 

Item 6. Exhibits and Reports on Form 8-K

 

(a) Exhibits

 

(31.1) Certification Pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act.

 

(31.2) Certification Pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act.

 

(32.1) Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

(32.2) Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

(b) Reports on Form 8-K:

 

TNMP filed an 8-K dated March 2, 2004 to report the issuance of its 2003 financial results.

 

Statement Regarding Forward Looking Information

 

The discussions in this document that are not historical facts, including, but not limited to, future cash flows and the potential recovery of stranded costs are based upon current expectations. Actual results may differ materially. Among the facts that could cause the results to differ materially from expectations are the following: the ability of TNP’s subsidiaries to adapt to open market competition; the ability of First Choice to attract and retain customers as competition moves forward; changes to First Choice purchased power costs resulting from the ERCOT settlement process; the effects of accounting pronouncements that may be issued periodically; changes in regulations affecting TNP’s businesses; decisions in connection with regulatory proceedings including PUCT Docket No. 29206, the stranded cost true-up proceeding of TNMP; insurance coverage available for claims made in litigation; general business and economic conditions; price fluctuations in the electric power and natural gas markets; collections experience; and other factors described from time to time in TNP’s reports filed with the Securities and Exchange Commission. TNP wishes to caution readers not to place undue reliance on any such forward looking statements, which are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

(Registrant)

 

TNP ENTERPRISES, INC.

Date: May 4, 2004

 

By

 

\s\ WILLIAM J. CATACOSINOS


       

William J. Catacosinos

       

Chief Executive Officer

Date: May 4, 2004

 

By

 

\s\ THEODORE A. BABCOCK


       

Theodore A. Babcock

       

Chief Financial Officer

 

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