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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 September 30, 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 September 30, 2004

 

TABLE OF CONTENTS

 

PART 1. FINANCIAL STATEMENTS     

Item 1.

   Financial Statements.     
     TNP Enterprises, Inc. (TNP) and Subsidiaries:     
               Consolidated Statements of Income (Loss) Three and Nine Month Periods Ended September 30, 2004 and 2003    3
               Consolidated Statements of Comprehensive Income (Loss) Three and Nine Month Periods Ended September 30, 2004 and 2003    4
               Consolidated Statements of Cash Flows Nine Month Periods Ended September 30, 2004 and 2003    5
               Consolidated Balance Sheets September 30, 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    19

Item 4.

   Controls and Procedures    28
PART 2. OTHER INFORMATION     

Item 1.

   Legal Proceedings    29

Item 6.

   Exhibits and Reports on Form 8-K    29
     (a)    Exhibit Index    29
     (b)    Reports on Form 8-K    29
     Statement Regarding Forward Looking Information    29

Signature page

   30

Certifications

   31

 

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Table of Contents

TNP ENTERPRISES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(Unaudited)

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (In thousands)  

OPERATING REVENUES

   $ 216,637     $ 252,687     $ 556,291     $ 659,933  
    


 


 


 


OPERATING EXPENSES:

                                

Purchased power

     109,416       143,144       276,909       418,137  

Other operating and maintenance

     47,622       55,837       142,004       162,847  

Accrual for payment (credit) to TNMP

     —         3,589       (48 )     4,008  

Depreciation

     7,541       7,277       22,471       21,597  

Taxes other than income taxes

     8,362       8,328       22,652       22,037  
    


 


 


 


Total operating expenses

     172,941       218,175       463,988       628,626  
    


 


 


 


OPERATING INCOME

     43,696       34,512       92,303       31,307  
    


 


 


 


INTEREST CHARGES, PREFERRED DIVIDENDS, AND OTHER INCOME AND DEDUCTIONS:

                                

Interest on long-term debt

     15,535       15,416       46,620       43,915  

Other interest and amortization of debt-related costs

     1,097       2,669       3,330       6,035  

Dividends on preferred stock and other

     6,327       —         18,561       —    

Carrying charges on deferred stranded costs

     (928 )     —         (928 )     —    

Other income and deductions, net

     (334 )     (787 )     (1,378 )     (1,663 )
    


 


 


 


Total

     21,697       17,298       66,205       48,287  
    


 


 


 


INCOME (LOSS) BEFORE INCOME TAXES

     21,999       17,214       26,098       (16,980 )

Income tax expenses (benefits)

     10,443       6,698       15,966       (6,452 )
    


 


 


 


INCOME (LOSS) BEFORE EXTRAORDINARY ITEM

     11,556       10,516       10,132       (10,528 )

Extraordinary item - disallowance of stranded costs, net of taxes (Note 3)

     —         —         (97,836 )     —    
    


 


 


 


NET INCOME (LOSS)

     11,556       10,516       (87,704 )     (10,528 )

Dividends on preferred stock and other

     —         5,515       —         16,179  
    


 


 


 


INCOME (LOSS) APPLICABLE TO COMMON STOCK

   $ 11,556     $ 5,001     $ (87,704 )   $ (26,707 )
    


 


 


 


 

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
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 
     (In thousands)  

NET INCOME (LOSS)

   $ 11,556     $ 10,516     $ (87,704 )   $ (10,528 )
    


 


 


 


Other comprehensive income, net of tax:

                                

Gas hedge, net of reclassification adjustment (Note 5)

     (2,297 )     (2,563 )     (2,456 )     (4,825 )

Interest rate hedge, net of reclassification adjustment (Note 5)

     255       364       702       (1,271 )
    


 


 


 


Total other comprehensive income

     (2,042 )     (2,199 )     (1,754 )     (6,096 )
    


 


 


 


COMPREHENSIVE INCOME (LOSS)

   $ 9,514     $ 8,317     $ (89,458 )   $ (16,624 )
    


 


 


 


 

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)

 

     Nine Months Ended
September 30,


 
     2004

    2003

 
     (In thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES:

                

Cash received from sales to customers

   $ 528,387     $ 613,008  

Purchased power costs paid

     (276,484 )     (389,594 )

Natural gas option premiums paid

     —         (19,642 )

Cash paid for payroll and to other suppliers

     (119,763 )     (140,041 )

Interest paid, net of amounts capitalized

     (38,822 )     (39,023 )

Income taxes refunded

     673       585  

Other taxes paid

     (21,975 )     (19,877 )

Other operating cash receipts and payments, net

     863       751  
    


 


NET CASH PROVIDED BY OPERATING ACTIVITIES

     72,879       6,167  
    


 


CASH FLOWS FROM INVESTING ACTIVITIES:

                

Additions to utility plant and other investing activities

     (34,519 )     (28,361 )
    


 


NET CASH USED IN INVESTING ACTIVITIES

     (34,519 )     (28,361 )
    


 


CASH FLOWS FROM FINANCING ACTIVITIES:

                

Issuances:

                

TNMP senior notes, net of discount

     —         248,923  

TNP senior secured credit facility

     —         112,500  

Repayments to TNMP/First Choice credit facility - net

     —         (171,000 )

Redemptions:

                

TNMP senior notes

     (8,375 )     —    

TNP senior secured credit facility

     (844 )     (281 )

TNP term loan

     —         (71,300 )

Financing and redemption costs

     (1,033 )     (5,534 )
    


 


NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES

     (10,252 )     113,308  
    


 


NET CHANGE IN CASH AND CASH EQUIVALENTS

     28,108       91,114  

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     117,788       16,690  
    


 


CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 145,896     $ 107,804  
    


 


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

                

Net loss

   $ (87,704 )   $ (10,528 )

Adjustments to reconcile net loss to net cash provided by operating activities:

                

Extraordinary item - disallowance of stranded costs, net of taxes

     97,836       —    

Accrued dividends on preferred stock and other

     18,561       —    

Accrual for payment (credit) to TNMP

     (48 )     4,008  

Depreciation

     22,471       21,597  

Credit for Texas system benefit fund regulatory asset

     (244 )     (3,960 )

Amortization of debt-related costs and other deferred charges

     3,331       6,171  

Carrying charges on deferred stranded costs

     (928 )     —    

Allowance for funds used during construction

     (661 )     (693 )

Deferred income taxes

     28,070       1,573  

Investment tax credits

     (794 )     (635 )

Deferred purchased power and fuel costs

     540       2,513  

Cash flows impacted by changes in current assets and liabilities:

                

Accounts receivable

     (1,997 )     (21,815 )

Accounts payable

     (4,567 )     20,432  

Accrued interest

     8,108       9,333  

Accrued taxes

     (9,000 )     (4,622 )

Changes in other current assets and liabilities

     (1,086 )     (5,131 )

Interest rate lock on issuance of senior notes

     —         (4,162 )

Other, net

     991       (7,914 )
    


 


NET CASH PROVIDED BY OPERATING ACTIVITIES

   $ 72,879     $ 6,167  
    


 


SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

                

Payment of dividends on preferred stock by issuance of additional preferred shares

   $ 11,595     $ 10,080  
    


 


 

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

 

    

September 30,

2004
(Unaudited)


    December 31,
2003


 
     (In thousands)  

ASSETS

                

CURRENT ASSETS:

                

Cash and cash equivalents

   $ 145,896     $ 117,788  

Special deposits

     3,081       2,520  

Accounts receivable, net

     96,984       94,987  

Federal income tax receivable

     20,293       —    

Materials and supplies, at lower of cost or market

     1,235       1,082  

Gas hedges

     1,435       6,237  

Other current assets

     4,130       2,914  
    


 


Total current assets

     273,054       225,528  
    


 


UTILITY PLANT:

                

Electric plant

     683,238       642,732  

Construction work in progress

     5,285       13,666  
    


 


Total

     688,523       656,398  

Less accumulated depreciation

     115,650       94,974  
    


 


Net utility plant

     572,873       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

     88,244       298,651  

Regulatory tax assets

     2,362       1,685  

Deferred charges

     48,996       49,956  
    


 


Total long-term and other assets

     411,131       621,821  
    


 


     $ 1,257,058     $ 1,408,773  
    


 


LIABILITIES AND SHAREHOLDER’S EQUITY

                

CURRENT LIABILITIES:

                

Current maturities of long-term debt

   $ 1,125     $ 1,125  

Accounts payable

     50,287       57,379  

Accrued interest

     23,387       15,279  

Accrued taxes

     18,047       6,754  

Accrued payroll and benefits

     4,426       5,367  

Customers’ deposits

     7,999       6,342  

Other current liabilities

     5,697       5,689  
    


 


Total current liabilities

     110,968       97,935  
    


 


LONG-TERM AND OTHER LIABILITIES:

                

Deferred purchased power and fuel costs

     —         40,844  

Accumulated deferred income taxes

     106,275       136,882  

Accumulated deferred investment tax credits

     2,564       18,459  

Regulatory liability-accrued cost of removal

     40,013       38,218  

Deferred credits and other liabilities

     52,958       52,283  

Long-term debt, less current maturities

     800,463       809,439  

Redeemable cumulative preferred stock

     181,100       162,538  
    


 


Total long-term and other liabilities

     1,183,373       1,258,663  
    


 


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

     (136,197 )     (48,493 )

Accumulated other comprehensive income-gas hedge

     888       3,344  

Accumulated other comprehensive loss-other

     (1,974 )     (2,676 )
    


 


Total common shareholder’s equity

     (37,283 )     52,175  
    


 


COMMITMENTS AND CONTINGENCIES (Note 9)

                
    


 


     $ 1,257,058     $ 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.

 

Except as noted otherwise, 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. Proposed PNM Resources, Inc., Acquisition of TNP Enterprises, Inc.

 

On July 24, 2004, SW Acquisition, L.P., the sole holder of TNP common stock, entered into an agreement (“Stock Purchase Agreement”) to sell all of the outstanding common stock of TNP to PNM Resources, Inc. (PNM Resources) for approximately $189 million comprised of equal amounts of PNM Resources common stock and cash. PNM Resources will also assume approximately $835 million of TNP’s net debt and senior redeemable cumulative preferred stock (“preferred securities”).

 

Under the terms of the agreement, TNP’s common shareholders will receive approximately $189 million in consideration, consisting of approximately 4.7 million newly issued PNM Resources shares and the remainder being paid in cash, subject to closing adjustments. The existing indebtedness and preferred securities at TNP will be retired. All debt at TNMP, TNP’s wholly-owned electric utility subsidiary, will remain outstanding.

 

Based on the number of common shares outstanding on a fully diluted basis and taking into account additional equity issuances, following the transaction, PNM Resources’ shareholders would own 94 percent of the PNM Resources’ common equity, and TNP’s shareholders would own approximately 6 percent.

 

The transaction is subject to certain conditions, including, to the extent they are required, receipt of necessary orders or other actions by the Public Utility Commission of Texas (“PUCT”), New Mexico Public Regulation Commission (“NMPRC”), the Federal Energy Regulatory Commission (“FERC”), the Securities and Exchange Commission (“SEC”) and clearance under applicable federal anti-trust statutes. Information regarding the approval status in each jurisdiction is as follows:

 

Texas. On September 9, 2004, TNMP and PNM Resources filed a joint application with the PUCT seeking a finding that the acquisition is in the public interest. Various parties have intervened. The PUCT has adopted a schedule under which Management expects an order to be issued in April 2005.

 

New Mexico. On September 9, 2004, TNMP and PNM Resources filed a joint application with the NMPRC seeking approval of the acquisition. Various parties have intervened. The NMPRC has adopted a schedule under which hearings begin on March 28, 2005. Management expects that an order will be issued in the second quarter of 2005.

 

FERC. TNMP and PNM Resources expect to file a joint application requesting approval of the acquisition with FERC in late November 2004.

 

SEC. PNM Resources expects to file for all required SEC action in accordance with the timetables adopted by the SEC.

 

The transaction is also subject to certain rights of termination by each party, including rights of termination in the event that required regulatory action is denied or not received. The Stock Purchase Agreement may also be terminated if the closing has not occurred on or prior to December 31, 2005.

 

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Note 3. 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 one 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 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 the 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 until January 1, 2005.

 

On June 1, 2004, several changes to customer protection rules in Texas became effective. 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 June 2, 2004, First Choice established a wholly owned bankruptcy remote Special Purpose Entity (SPE). The SPE holds 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. First Choice issued a filing with the PUCT on August 13, 2004, stating that it has complied with the terms of the final order in Docket No. 29081, which approved First Choice’s request to establish a bankruptcy remote SPE.

 

2004 True-Up Proceeding. On July 22, 2004, the PUCT issued its decision in TNMP’s stranded cost true-up proceeding in Docket No. 29206. The PUCT decision allows TNMP to recover $87.3 million of the $266.5 million that TNMP requested as stranded costs. TNMP’s original request included approximately $307.6 million of stranded costs related to the sale of TNP One, which occurred in October 2002, and a credit of approximately $41.1 million related to TNMP’s over-recovered balance of fuel and energy-related purchased power costs.

 

The PUCT’s decision resulted in a loss of $155.1 million before an income tax benefit of $57.3 million ($97.8 million after tax). TNMP recorded the $97.8 million after tax loss as an extraordinary item in the second quarter of 2004. The loss was classified as an extraordinary item in accordance with SFAS 101, “Regulated Enterprises – Accounting for the Discontinuance of the Application of FASB Statement No. 71.”

 

In addition to the decision regarding stranded costs, the PUCT order confirmed that First Choice’s clawback liability to TNMP is $15.9 million.

 

In the decision, the PUCT found that TNMP’s selection of an affiliate of TNMP to serve as its financial advisor to the sale of TNP One, as well as deficiencies in the process, resulted in a sale transaction that was not a bona fide third party transaction under a competitive offering. Additionally, the PUCT disallowed costs associated with TNMP’s failure to reduce costs associated with a renegotiated long-term lignite contract. Also, the PUCT grossed up certain disallowances for income tax effects. TNMP disagrees with the PUCT decision, and intends to vigorously pursue all avenues of appeal of this order.

 

In the third quarter of 2004, TNMP began accruing carrying charges on stranded costs for the period subsequent to the July 22, 2004 stranded cost order. In accordance with PUCT rules, TNMP is allowed to accrue and recover carrying charges on the stranded cost balance from the date of the final order.

 

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On August 11, 2004, TNMP filed a motion for rehearing of the PUCT decision. On October 7, 2004, the PUCT denied all of TNMP’s motions for rehearing except for an issue related to a recent Texas Supreme Court ruling which addressed recovery of carrying charges on recoverable stranded costs back to January 1, 2002, the date that competition began in Texas. A hearing is scheduled in December 2004. The sole issue under consideration is expected to be the recovery of carrying charges on the recoverable stranded costs retroactive to January 1, 2002, and a final order in the True-Up Proceeding is expected to be issued in the first quarter of 2005.

 

60-Day Rate Review. Sixty days following the issuance of a final stranded cost true-up order, TNMP is required to make a 60-Day Rate Review filing. The review will set rates for recovery of stranded costs, address the clawback liability and allow for a reset of First Choice price-to-beat rates.

 

Price-to-Beat Fuel Factor. Effective July 7, 2004, First Choice increased its price-to-beat fuel factor by 8.3% following the PUCT’s approval of a request that First Choice made in May 2004. First Choice estimates that the July 2004 increase in the price-to-beat fuel factor will increase annual revenues by approximately $9.0 million.

 

On October 29, 2004, First Choice filed to increase its price-to-beat fuel factor by 15.4%. The filing is in response to recent increases in market natural gas prices. First Choice estimates that the price-to-beat fuel factor will increase annual revenues by approximately $16.7 million. First Choice expects the PUCT to approve the increase in December 2004. The October 2004 price-to-beat fuel filing was First Choice’s second for 2004, the maximum number of changes to the price-to-beat fuel filing that First Choice is allowed to request for 2004.

 

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. Due to the passage of time, these rate reviews are no longer effective.

 

New Mexico

 

Affiliate Guarantee. In October 2003, the NMPRC granted TNMP’s request for authority to extend a portion of the guarantees that TNMP provided for certain power supply obligations of First Choice. TNMP’s authority to guarantee the power supply obligations of First Choice terminated on June 2, 2004, when First Choice established a bankruptcy remote SPE under authorization granted by the PUCT in Docket No. 29081. The SPE was established in connection with First Choice’s power supply agreement with Constellation.

 

New Mexico Fuel and Purchased Power. In January 2002, as part of the final order in Docket No. 3643, TNMP established a fuel and purchased power cost adjustment clause (FPPCAC) in New Mexico. This clause allowed TNMP to recover actual purchased power costs from customers. New Mexico regulations require TNMP to seek approval for continuation of the FPPCAC every two years. In July 2004, the staff of the NMPRC notified TNMP that it had failed to file for the continuation of the FPPCAC.

 

Amounts collected from February through June 2004 are subject to refund. In September 2004, the NMPRC authorized TNMP to begin collecting an interim FFPCAC effective October 1, 2004, subject to refund. Hearings on a permanent FFPCAC are scheduled for the fourth quarter of 2004. TNMP’s earnings were reduced by $0.1 million and $0.5 million after tax ($0.1 million and $0.8 million before tax) for the three and nine months ended September 30, 2004, respectively, as a result of the temporary expiration of FFPCAC.

 

SEC Holding Company Exemption. In July 2004, TNP was notified by the SEC that it appeared that TNP does not meet the formal requirements for exemption under the Public Utility Holding Company Act. TNP responded by filing information with the SEC that demonstrates that TNP does meet the exemption requirements. Through November 3, 2004, TNP has received no response from the SEC.

 

Note 4. 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 6.

 

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

 

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adoption of SFAS 150, TNP reclassified the balance of its redeemable cumulative preferred stock at December 31, 2003, as a liability. For the nine months ended September 30, 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 $40.0 million and $38.2 million as of September 30, 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 5. 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 terminated in October 2004. Under the terms of the swap, TNP paid a fixed rate of approximately 2.5 percent and received variable rates that were set at approximately 1.6 percent. As of September 30, 2004, the variable interest rate on the Senior Credit Facility was approximately 7.4 percent, including the effects of the swap.

 

The fair value of TNP’s swap as of September 30, 2004, was a liability of $0.1 million, which is recorded on its balance sheet in deferred credits and other liabilities.

 

The interest rate swap is 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 and nine months ended September 30, 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 tables.

 

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Table of Contents
    

Three Months Ended

September 30, 2004


  

Nine Months Ended

September 30, 2004


 
     Before-Tax
Amount


   Tax Benefit
(Expense)


    After-Tax
Amount


   Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


 
     (In thousands)  

Change in market value

   $ 34    $ (13 )   $ 21    $ (132 )   $ 50     $ (82 )

Reclassification adjustments

     169      (64 )     105      641       (244 )     397  
    

  


 

  


 


 


Other comprehensive income (loss)

   $ 203    $ (77 )   $ 126    $ 509     $ (194 )   $ 315  
    

  


 

  


 


 


    

Three Months Ended

September 30, 2003


  

Nine Months Ended

September 30, 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

   $ 140    $ (53 )   $ 87    $ (669 )   $ 255     $ (414 )

Reclassification adjustments

     239      (91 )     148      619       (236 )     383  
    

  


 

  


 


 


Other comprehensive income (loss)

   $ 379    $ (144 )   $ 235    $ (50 )   $ 19     $ (31 )
    

  


 

  


 


 


 

Over the next twelve months TNP anticipates that $0.1 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 and nine months ended September 30, 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 tables.

 

    

Three Months Ended

September 30, 2004


  

Nine Months Ended

September 30, 2004


 
     Before-Tax
Amount


   Tax Benefit
(Expense)


    After-Tax
Amount


   Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


 
     (In thousands)  

Change in market value

   $ —      $ —       $ —      $ —       $ —       $ —    

Reclassification adjustments

     208      (79 )     129      625       (238 )     387  
    

  


 

  


 


 


Other comprehensive income (loss)

   $ 208    $ (79 )   $ 129    $ 625     $ (238 )   $ 387  
    

  


 

  


 


 


    

Three Months Ended

September 30, 2003


  

Nine Months Ended

September 30, 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

   $ —      $ —       $ —      $ (5,922 )   $ 2,256     $ (3,666 )

Reclassification adjustments

     208      (79 )     129      3,919       (1,493 )     2,426  
    

  


 

  


 


 


Other comprehensive income (loss)

   $ 208    $ (79 )   $ 129    $ (2,003 )   $ 763     $ (1,240 )
    

  


 

  


 


 


 

-11-


Table of Contents

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. 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 September 30, 2004, was an asset of $1.4 million, which is recorded on TNP’s balance sheet as a current asset. For the three and nine months ended September 30, 2004, First Choice’s purchased power expense includes pre-tax gains of $0.9 million ($0.6 million after tax) and $9.1 million ($5.6 million after tax), respectively, related to the settlement of natural gas swaps and options.

 

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 tables.

 

    

Three Months Ended

September 30, 2004


   

Nine Months Ended

September 30, 2004


 
     Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


    Before-Tax
Amount


    Tax Benefit
(Expense)


    After-Tax
Amount


 
     (In thousands)  

Change in market value

   $ (2,800 )   $ 1,067     $ (1,733 )   $ 5,082     $ (1,936 )   $ 3,146  

Reclassification adjustments

     (911 )     347       (564 )     (9,049 )     3,447       (5,602 )
    


 


 


 


 


 


Other comprehensive income (loss)

   $ (3,711 )   $ 1,414     $ (2,297 )   $ (3,967 )   $ 1,511     $ (2,456 )
    


 


 


 


 


 


    

Three Months Ended

September 30, 2003


   

Nine Months Ended

September 30, 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

   $ (10,723 )   $ 4,085     $ (6,638 )   $ (17,651 )   $ 6,725     $ (10,926 )

Reclassification adjustments

     6,583       (2,508 )     4,075       9,856       (3,755 )     6,101  
    


 


 


 


 


 


Other comprehensive income (loss)

   $ (4,140 )   $ 1,577     $ (2,563 )   $ (7,795 )   $ 2,970     $ (4,825 )
    


 


 


 


 


 


 

First Choice also estimates that $0.9 million of unrealized after-tax gains related to natural gas swaps will be reclassified through other comprehensive income to purchased power expense.

 

Note 6. 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.

 

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Table of Contents

The components of net periodic benefit cost of TNP’s employee benefit plans for the three and nine months ended September 30, 2004 and 2003 are shown in the following table (amounts in thousands).

 

    

Pension Benefits

Three Months Ended

September 30,


   

Postretirement Benefits

Three Months Ended

September 30,


 
     2004

    2003

    2004

    2003

 

Components of net periodic benefit cost

                                

Service cost

   $ 523     $ 524     $ 104     $ 97  

Interest cost

     1,197       1,292       199       172  

Expected return on plan assets

     (1,598 )     (1,559 )     (88 )     (78 )

Amortization of prior service cost

     5       5       —         —    

Amortization of transitional (asset) or obligation

     —         —         —         —    

Recognized actuarial (gain) loss

     501       419       107       55  
    


 


 


 


Net periodic benefit cost

   $ 628     $ 681     $ 322     $ 246  
    


 


 


 


    

Pension Benefits

Nine Months Ended

September 30,


   

Postretirement Benefits

Nine Months Ended

September 30,


 
     2004

    2003

    2004

    2003

 

Components of net periodic benefit cost

                                

Service cost

   $ 1,568     $ 1,573     $ 308     $ 291  

Interest cost

     3,591       3,876       509       515  

Expected return on plan assets

     (4,529 )     (4,867 )     (236 )     (240 )

Settlements

     —         163       —         —    

Amortization of prior service cost

     15       15       —         —    

Recognized actuarial (gain) loss

     1,505       1,257       209       164  
    


 


 


 


Net periodic benefit cost

   $ 2,150     $ 2,017     $ 790     $ 730  
    


 


 


 


 

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 7. 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 the three and nine month periods ended September 30, 2004, TNP paid Laurel Hill $0.1 million and $0.4 million, respectively, under the agreement. During the same time periods in 2003, TNP paid Laurel Hill $0.3 million and $0.9 million, respectively.

 

TNP also incurred fees of $0.3 million and $0.8 million for the three and nine months ended September 30, 2004, for advisory services by the original limited partners of SW Acquisition, pursuant to provisions of the SW Acquisition limited partnership agreement.

 

Note 8. 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).

 

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Table of Contents

Three Months Ended September 30, 2004

 

     Regulated
Transmission
and Distribution


    First
Choice


    All Other
and
Eliminations


    TNP
Consolidated


 

Income Statement Data

                                

Revenue from external customers

   $ 44,760     $ 171,877     $ —       $ 216,637  

Intercompany revenue

     29,972       —         (29,972 )     —    

Purchased power

     (19,628 )     (89,788 )     —         (109,416 )

Other direct costs

     (6,329 )     (46,653 )     29,542       (23,440 )

Depreciation expense

     (7,433 )     (107 )     (1 )     (7,541 )

Other operating expenses

     (18,502 )     (12,719 )     (1,323 )     (32,544 )
    


 


 


 


Operating income (loss)

     22,840       22,610       (1,754 )     43,696  

Other income and deductions, net

     1,136       99       (6,300 )     (5,065 )

Interest charges

     (6,971 )     (100 )     (9,561 )     (16,632 )
    


 


 


 


Income (loss) before taxes

     17,005       22,609       (17,615 )     21,999  

Income taxes

     (6,196 )     (8,131 )     3,884       (10,443 )

Extraordinary Items - disallowance of stranded cost (net of taxes)

     —         —         —         —    
    


 


 


 


Net income (loss)

     10,809       14,478       (13,731 )     11,556  

Dividends on preferred stock and other

     —         —         —         —    
    


 


 


 


Income (loss) applicable to common stock

   $ 10,809     $ 14,478     $ (13,731 )   $ 11,556  
    


 


 


 


Cash Flow Data

                                

Cash received from sales to customers

   $ 66,497     $ 161,704     $ (27,900 )   $ 200,301  

Purchased power costs paid

     (19,253 )     (76,324 )     —         (95,577 )

Cash paid for payroll and to other suppliers

     (10,208 )     (9,350 )     (1,121 )     (20,679 )

Transmission and distribution charges

     —         (44,081 )     27,471       (16,610 )

Interest and other taxes paid

     (7,801 )     (1,995 )     (2,112 )     (11,908 )

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

     (2,066 )     (3,616 )     5,921       239  
    


 


 


 


Net cash provided by (used in) operations

     27,169       26,338       2,259       55,766  
    


 


 


 


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

     (10,812 )     (862 )     —         (11,674 )
    


 


 


 


Borrowings from (repayments of) credit facilities

     —         —         (281 )     (281 )

Redemption of senior notes

     —         —         —         —    

Intercompany dividends

     —         (12,000 )     12,000       —    

Other

     —         —         —         —    
    


 


 


 


Net cash provided by (used in) financing activities

   $ —       $ (12,000 )   $ 11,719     $ (281 )
    


 


 


 


Balance Sheet Data as of September 30, 2004

                                

Cash and cash equivalents

   $ 58,833     $ 68,283     $ 18,780     $ 145,896  

Accounts receivable

     34,274       76,604       (13,894 )     96,984  

Other current assets

     30,388       2       (216 )     30,174  

Net utility plant

     568,996       3,862       15       572,873  

Goodwill

     —         —         270,256       270,256  

Recoverable stranded costs

     88,244       —         —         88,244  

Other property, regulatory tax assets and deferred charges

     31,381       39       21,211       52,631  
    


 


 


 


Total assets

   $ 812,116     $ 148,790     $ 296,152     $ 1,257,058  
    


 


 


 


Current maturities of long-term debt

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

Accounts payable

     9,762       53,493       (12,968 )     50,287  

Other current liabilities

     33,371       12,819       13,367       59,557  

Accumulated deferred income taxes and investment tax credits

     125,770       (7,204 )     (9,727 )     108,839  

Deferred credits

     24,022       15,878       13,058       52,958  

Regulatory liability-accrued cost of removal

     40,013       —         —         40,013  

Long-term debt, less current maturities

     415,495       —         384,968       800,463  

Redeemable cumulative preferred stock

     —         —         181,100       181,100  

Common shareholder's equity

     163,683       73,804       (274,771 )     (37,284 )
    


 


 


 


Total liabilities and shareholder's equity

   $ 812,116     $ 148,790     $ 296,152     $ 1,257,058  
    


 


 


 


 

-14-


Table of Contents

Three Months Ended September 30, 2003

 

     Regulated
Transmission
and Distribution


    First
Choice


    All Other
and
Eliminations


    TNP
Consolidated


 

Income Statement Data

                                

Revenue from external customers

   $ 40,054     $ 212,631     $ 2     $ 252,687  

Intercompany revenue

     29,899       —         (29,899 )     —    

Purchased power and fuel

     (17,542 )     (125,602 )     —         (143,144 )

Other direct costs

     (5,257 )     (60,125 )     29,502       (35,880 )

Depreciation expense

     (7,197 )     (79 )     (1 )     (7,277 )

Other operating expenses

     (14,273 )     (16,243 )     (1,358 )     (31,874 )
    


 


 


 


Operating income (loss)

     25,684       10,582       (1,754 )     34,512  

Other income and deductions, net

     783       (21 )     25       787  

Interest charges

     (6,869 )     (363 )     (10,853 )     (18,085 )
    


 


 


 


Income (loss) before taxes

     19,598       10,198       (12,582 )     17,214  

Income taxes

     (7,295 )     (3,681 )     4,278       (6,698 )
    


 


 


 


Net income (loss)

     12,303       6,517       (8,304 )     10,516  

Dividends on preferred stock and other

     —         —         5,515       5,515  
    


 


 


 


Income (loss) applicable to common stock

   $ 12,303     $ 6,517     $ (13,819 )   $ 5,001  
    


 


 


 


Cash Flow Data

                                

Cash received from customers

   $ 69,951     $ 212,854     $ (32,520 )   $ 250,285  

Purchased power and fuel costs paid

     (16,060 )     (140,534 )     —         (156,594 )

Natural gas option premiums paid

     —         (495 )     —         (495 )

Cash paid for payroll and to other suppliers

     (11,098 )     (7,246 )     (1,438 )     (19,782 )

Transmission and distribution charges

     —         (59,683 )     32,126       (27,557 )

Interest and other taxes paid

     (8,110 )     (1,901 )     (1,285 )     (11,296 )

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

     (3,000 )     (20 )     3,212       192  
    


 


 


 


Net cash provided by (used in) operations

     31,683       2,975       95       34,753  
    


 


 


 


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

     (8,238 )     (44 )     (5 )     (8,287 )
    


 


 


 


Borrowings from (repayments of) credit facilities

     —         (7,000 )     (70,781 )     (77,781 )

Issuance of senior notes, net of discount

     —         —         —         —    

Issuance of term loan under TNP senior credit facility

     —         —         112,500       112,500  

Intercompany dividends

     —         —         —         —    

Intercompany financing

     —         25,000       (25,000 )     —    

Intercompany borrowing

     —         —         —         —    

Other

     (176 )     (322 )     (2,704 )     (3,202 )
    


 


 


 


Net cash provided by (used in) financing activities

   $ (176 )   $ 17,678     $ 14,015     $ 31,517  
    


 


 


 


Balance Sheet Data as of September 30, 2003

                                

Cash and cash equivalents

   $ 65,218     $ 22,493     $ 20,093     $ 107,804  

Accounts receivable

     31,349       99,297       (14,447 )     116,199  

Other current assets

     2,088       3,732       101       5,921  

Net utility plant

     511,316       2,810       22       514,148  

Goodwill

     —         —         270,256       270,256  

Recoverable stranded costs

     298,748       —         —         298,748  

Other property, regulatory tax assets and deferred charges

     28,621       363       21,170       50,154  
    


 


 


 


Total assets

   $ 937,340     $ 128,695     $ 297,195     $ 1,363,230  
    


 


 


 


Current maturities of long-term debt

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

Accounts payable

     8,602       67,207       (13,390 )     62,419  

Other current liabilities

     35,344       9,297       3,697       48,338  

Deferred purchased power and fuel costs

     24,321       —         —         24,321  

Accumulated deferred income taxes and investment tax credits

     172,842       (11,149 )     (10,169 )     151,524  

Deferred credits

     24,142       16,733       11,072       51,947  

Long-term debt, less current maturities

     423,552       —         386,093       809,645  

Redeemable cumulative preferred stock

     —         —         156,631       156,631  

Common shareholder’s equity

     248,537       46,607       (237,864 )     57,280  
    


 


 


 


Total liabilities and shareholder’s equity

   $ 937,340     $ 128,695     $ 297,195     $ 1,363,230  
    


 


 


 


 

-15-


Table of Contents

Nine Months Ended September 30, 2004

 

     Regulated
Transmission
and Distribution


    First
Choice


    All Other
and
Eliminations


    TNP
Consolidated


 

Income Statement Data

                                

Revenue from external customers

   $ 127,117     $ 429,174     $ —       $ 556,291  

Intercompany revenue

     74,337       —         (74,337 )     —    

Purchased power

     (54,600 )     (222,309 )     —         (276,909 )

Other direct costs

     (19,001 )     (123,715 )     73,046       (69,670 )

Depreciation expense

     (22,186 )     (282 )     (3 )     (22,471 )

Other operating expenses

     (54,186 )     (36,292 )     (4,460 )     (94,938 )
    


 


 


 


Operating income (loss)

     51,481       46,576       (5,754 )     92,303  

Other income and deductions, net

     2,022       201       (18,478 )     (16,255 )

Interest charges

     (21,105 )     (262 )     (28,583 )     (49,950 )
    


 


 


 


Income (loss) before taxes

     32,398       46,515       (52,815 )     26,098  

Income taxes

     (11,245 )     (16,656 )     11,935       (15,966 )

Extraordinary Items - disallowance of stranded cost (net of taxes)

     (97,836 )     —         —         (97,836 )
    


 


 


 


Net income (loss)

     (76,683 )     29,859       (40,880 )     (87,704 )

Dividends on preferred stock and other

     —         —         —         —    
    


 


 


 


Income (loss) applicable to common stock

   $ (76,683 )   $ 29,859     $ (40,880 )   $ (87,704 )
    


 


 


 


Cash Flow Data

                                

Cash received from sales to customers

   $ 177,757     $ 422,526     $ (71,896 )   $ 528,387  

Purchased power costs paid

     (53,909 )     (222,575 )     —         (276,484 )

Cash paid for payroll and to other suppliers

     (34,951 )     (28,040 )     (4,228 )     (67,219 )

Transmission and distribution charges

     —         (123,162 )     70,618       (52,544 )

Interest and other taxes paid

     (35,567 )     (4,603 )     (20,627 )     (60,797 )

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

     (2,945 )     (7,552 )     12,033       1,536  
    


 


 


 


Net cash provided by (used in) operations

     50,385       36,594       (14,100 )     72,879  
    


 


 


 


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

     (33,163 )     (1,356 )     —         (34,519 )
    


 


 


 


Borrowings from (repayments of) credit facilities

     —         —         (844 )     (844 )

Redemption of senior notes

     (8,375 )     —         —         (8,375 )

Intercompany dividends

     (6,000 )     (12,000 )     18,000       —    

Other

     (921 )     —         (112 )     (1,033 )
    


 


 


 


Net cash provided by (used in) financing activities

   $ (15,296 )   $ (12,000 )   $ 17,044     $ (10,252 )
    


 


 


 


Balance Sheet Data as of September 30, 2004

                                

Cash and cash equivalents

   $ 58,833     $ 68,283     $ 18,780     $ 145,896  

Accounts receivable

     34,274       76,604       (13,894 )     96,984  

Other current assets

     30,388       2       (216 )     30,174  

Net utility plant

     568,996       3,862       15       572,873  

Goodwill

     —         —         270,256       270,256  

Recoverable stranded costs

     88,244       —         —         88,244  

Other property, regulatory tax assets and deferred charges

     31,381       39       21,211       52,631  
    


 


 


 


Total assets

   $ 812,116     $ 148,790     $ 296,152     $ 1,257,058  
    


 


 


 


Current maturities of long-term debt

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

Accounts payable

     9,762       53,493       (12,968 )     50,287  

Other current liabilities

     33,371       12,819       13,367       59,557  

Accumulated deferred income taxes and investment tax credits

     125,770       (7,204 )     (9,727 )     108,839  

Deferred credits

     24,022       15,878       13,058       52,958  

Regulatory liability-accrued cost of removal

     40,013       —         —         40,013  

Long-term debt, less current maturities

     415,495       —         384,968       800,463  

Redeemable cumulative preferred stock

     —         —         181,100       181,100  

Common shareholder’s equity

     163,683       73,804       (274,771 )     (37,284 )
    


 


 


 


Total liabilities and shareholder’s equity

   $ 812,116     $ 148,790     $ 296,152     $ 1,257,058  
    


 


 


 


 

-16-


Table of Contents

Nine Months Ended September 30, 2003

 

     Regulated
Transmission
and Distribution


    First
Choice


    All Other
and
Eliminations


    TNP
Consolidated


 

Income Statement Data

                                

Revenue from external customers

   $ 115,263     $ 544,668     $ 2     $ 659,933  

Intercompany revenue

     83,816       —         (83,816 )     —    

Purchased power and fuel

     (50,920 )     (367,294 )     77       (418,137 )

Other direct costs

     (15,616 )     (162,702 )     82,626       (95,692 )

Depreciation expense

     (21,374 )     (219 )     (4 )     (21,597 )

Other operating expenses

     (47,939 )     (41,221 )     (4,040 )     (93,200 )
    


 


 


 


Operating income (loss)

     63,230       (26,768 )     (5,155 )     31,307  

Other income and deductions, net

     1,631       91       (59 )     1,663  

Interest charges

     (20,647 )     (982 )     (28,321 )     (49,950 )
    


 


 


 


Income (loss) before taxes

     44,214       (27,659 )     (33,535 )     (16,980 )

Income taxes

     (16,031 )     10,757       11,726       6,452  
    


 


 


 


Net income (loss)

     28,183       (16,902 )     (21,809 )     (10,528 )

Dividends on preferred stock and other

     —         —         16,179       16,179  
    


 


 


 


Income (loss) applicable to common stock

   $ 28,183     $ (16,902 )   $ (37,988 )   $ (26,707 )
    


 


 


 


Cash Flow Data

                                

Cash received from customers

   $ 188,758     $ 510,507     $ (86,257 )   $ 613,008  

Purchased power and fuel costs paid

     (49,192 )     (340,185 )     (217 )     (389,594 )

Natural gas option premiums paid

     —         (19,642 )     —         (19,642 )

Cash paid for payroll and to other suppliers

     (42,560 )     (28,039 )     (3,860 )     (74,459 )

Transmission and distribution charges

     —         (150,657 )     85,075       (65,582 )

Interest and other taxes paid

     (37,399 )     (4,097 )     (17,404 )     (58,900 )

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

     (9,969 )     675       10,630       1,336  
    


 


 


 


Net cash provided by (used in) operations

     49,638       (31,438 )     (12,033 )     6,167  
    


 


 


 


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

     (28,087 )     (271 )     (3 )     (28,361 )
    


 


 


 


Borrowings from (repayments of) credit facilities

     (171,000 )     —         (71,581 )     (242,581 )

Issuance of senior notes, net of discount

     248,923       —         —         248,923  

Issuance of term loan under TNP senior credit facility

     —         —         112,500       112,500  

Intercompany dividends

     (18,400 )     —         18,400       —    

Intercompany financing

     —         35,000       (35,000 )     —    

Intercompany borrowing

     (14,557 )     14,557       —         —    

Other

     (1,583 )     (568 )     (3,383 )     (5,534 )
    


 


 


 


Net cash provided by (used in) financing activities

   $ 43,383     $ 48,989     $ 20,936     $ 113,308  
    


 


 


 


Balance Sheet Data as of September 30, 2003

                                

Cash and cash equivalents

   $ 65,218     $ 22,493     $ 20,093     $ 107,804  

Accounts receivable

     31,349       99,297       (14,447 )     116,199  

Other current assets

     2,088       3,732       101       5,921  

Net utility plant

     511,316       2,810       22       514,148  

Goodwill

     —         —         270,256       270,256  

Recoverable stranded costs

     298,748       —         —         298,748  

Other property, regulatory tax assets and deferred charges

     28,621       363       21,170       50,154  
    


 


 


 


Total assets

   $ 937,340     $ 128,695     $ 297,195     $ 1,363,230  
    


 


 


 


Current maturities of long-term debt

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

Accounts payable

     8,602       67,207       (13,390 )     62,419  

Other current liabilities

     35,344       9,297       3,697       48,338  

Deferred purchased power and fuel costs

     24,321       —         —         24,321  

Accumulated deferred income taxes and investment tax credits

     172,842       (11,149 )     (10,169 )     151,524  

Deferred credits

     24,142       16,733       11,072       51,947  

Long-term debt, less current maturities

     423,552       —         386,093       809,645  

Redeemable cumulative preferred stock

     —         —         156,631       156,631  

Common shareholder’s equity

     248,537       46,607       (237,864 )     57,280  
    


 


 


 


Total liabilities and shareholder’s equity

   $ 937,340     $ 128,695     $ 297,195     $ 1,363,230  
    


 


 


 


 

-17-


Table of Contents

As of September 30, 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. As discussed in Note 3, TNMP recorded an after tax loss of $97.8 million in the second quarter of 2004 related to the PUCT true-up proceeding regarding TNMP’s stranded costs. TNP did not assign goodwill to the Regulated Transmission and Distribution segment based upon the potential cash flows resulting from stranded cost recovery. Accordingly, the loss recorded as a result of the PUCT decision in the true-up proceeding did not result in impairment of the goodwill assigned to the Regulated Transmission and Distribution segment.

 

Note 9. 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 operations. As a result, First Choice has secured supply to serve most of its forecasted commitments to existing competitive customers for 2004 at fixed prices. In addition, First Choice has fixed the price of energy for forecasted commitments to price-to-beat customers through December 2004.

 

First Choice 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 ended on June 1, 2004. On that date, phase three commenced and First Choice transferred all of First Choice’s customers and receivables into a bankruptcy remote subsidiary, First Choice Power Special Purpose, LP (SPE), which operates as a retail electric provider, as discussed in Note 3. First Choice took this action to comply with the PUCT order issued on March 16, 2004 that authorized the transfer of customers to the SPE.

 

The SPE holds all customer contracts and wholesale power and natural gas contracts previously held by First Choice. Constellation received a lien against the assets of SPE, including billed and unbilled receivables, all cash of the SPE, customer contracts, and the equity of the SPE, to cover the settlement exposure and mark-to-market exposure rather than requiring the SPE to post alternate collateral for purchase power supply. In addition, the SPE is restricted by covenants that limit the size of the SPE’s unhedged market positions and require that sales by the SPE retain a positive retail margin. The agreement does not, however, permit Constellation to demand additional collateral irrespective of its credit exposure under the agreement. If, however, a change in electricity or gas forward prices increases Constellation’s credit exposure to the SPE beyond a limit based on Constellation’s liens in cash and accounts receivable, Constellation will have no obligation to supply additional customers of the SPE unless the SPE provides letters of credit or other collateral acceptable to Constellation, and the SPE will be constrained in its ability to sign up additional customers until that credit shortfall is corrected. In connection with the formation of the SPE, Constellation released TNMP from its $25 million guarantee of certain power supply obligations of First Choice.

 

Phase three commitments to supply power for new customers will continue until December 31, 2006, although Constellation has agreed to supply power in certain transactions under the agreement beyond the date when that commitment expires. The SPE may terminate the agreement upon thirty days prior notice to Constellation, for any reason, but the agreement and all liens securing the agreement remain in effect with respect to transactions entered into prior to the termination, until both parties have fulfilled all of their obligations with respect to such transactions or such transactions have been terminated for default or certain reasons related to regulatory changes. Provisions of the power supply agreements that by their terms survive terminations would expire on their original expiration dates.

 

Environmental Site. In October, 2003, the Texas Commission on Environmental Quality (TCEQ) notified approximately fifty companies, including TNMP, that releases of hazardous substances had been documented from a site owned and operated by a vendor with whom those companies did business. TNMP purchased transformers from the vendor and also sent some transformers to the vendor for repair and/or disposal. The owner and operator of the site has filed for bankruptcy and the site is under the control of the bankruptcy trustee. In August 2004, fifteen of the companies identified by TCEQ as potentially responsible parties (PRPs), including TNMP, formed an initial working group to manage the remediation efforts and determine the allocation of responsibility among the PRPs. As a result of the initial allocation of responsibility, TNMP recorded a liability of $0.6 million for its share of the clean up of this site in the third quarter of 2004.

 

-18-


Table of Contents

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.

 

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 3, 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 September 30, 2004, First Choice served approximately 166,000 customers at price-to-beat rates and approximately 54,000 customers at competitive rates. At September 30, 2003, First Choice served approximately 179,000 and 74,000 price-to-beat and competitive customers, respectively. In response to the factors discussed in Bad Debt and Delinquency, below, First Choice has not actively pursued mass market customers. Mass market customers who choose First Choice as their retail electric provider may be required to make a deposit before First Choice begins service.

 

Bad Debt and Delinquency. Under PUCT rules prior to June 1, 2004, First Choice had the right to disconnect customers that reside in TNMP’s transmission and distribution service territory for nonpayment. However, First Choice was prohibited from disconnecting customers who resided outside TNMP’s transmission and distribution service territory for nonpayment, but could transfer such a customer to the affiliated retail electric provider of the transmission and distribution service provider that served the transferred customer.

 

The structure described above limited First Choice’s collection activities, and affected 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 September 30, 2004, compared with 1.6 percent at September 30, 2003. On average, delinquent accounts receivable were approximately 7.1 percent of monthly operating revenue for the nine months ended September 30, 2004, compared with a 4.6 percent delinquency rate for the nine months ended September 30, 2003.

 

As discussed in Note 3, the PUCT has implemented changes to the current customer protection rules. As a result, First Choice began disconnecting customers that reside outside of TNMP’s transmission and distribution service territory for nonpayment in June 2004. Prior to the change in customer protection rules, First Choice was only able to disconnect customers within TNMP’s transmission and distribution service territory for nonpayment. First Choice expects that both its bad debt and delinquency rates will decrease for competitive customers as it implements more aggressive credit and collection policies based on the new customer protection rules.

 

First Choice Energy Supply

 

Strategy for mitigating fluctuation in costs of energy supply. 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 operations. As a result, First Choice has secured supply to serve most of its forecasted commitments to existing competitive customers for 2004 at fixed prices. In addition, First Choice has fixed the price of energy for forecasted commitments to price-to-beat customers through December 2004.

 

First Choice 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 ended on June 1, 2004. On that date, phase three commenced and First Choice transferred all of First Choice’s customers and receivables into a bankruptcy remote subsidiary, First Choice Power Special Purpose, LP (SPE), which operates as a retail electric provider, as discussed in Note 3. First Choice took this action to comply with the PUCT order issued on March 16, 2004 that authorized the transfer of customers to the SPE.

 

The SPE holds all customer contracts and wholesale power and natural gas contracts previously held by First Choice. Constellation received a lien against the assets of SPE, including billed and unbilled receivables, all cash of the SPE, customer contracts, and the equity of the SPE, to cover the settlement exposure and mark-to-market exposure rather than requiring the SPE to post alternate collateral for purchase power supply. In addition, the SPE is restricted by covenants that limit the size of the SPE’s unhedged market positions and require that sales by the SPE retain a positive retail margin. The agreement does not, however, permit Constellation to demand additional collateral irrespective of its credit exposure under the agreement. If, however, a change in electricity or gas forward prices increases Constellation’s credit exposure to the SPE

 

-19-


Table of Contents

beyond a limit based on Constellation’s liens in cash and accounts receivable, Constellation will have no obligation to supply additional customers of the SPE unless the SPE provides letters of credit or other collateral acceptable to Constellation, and the SPE will be constrained in its ability to sign up additional customers until that credit shortfall is corrected. In connection with the formation of the SPE, Constellation released TNMP from its $25 million guarantee of certain power supply obligations of First Choice.

 

Phase three commitments to supply power for new customers will continue until December 31, 2006, although Constellation has agreed to supply power in certain transactions under the agreement beyond the date when that commitment expires. The SPE may terminate the agreement upon thirty days prior notice to Constellation, for any reason, but the agreement and all liens securing the agreement remain in effect with respect to transactions entered into prior to the termination, until both parties have fulfilled all of their obligations with respect to such transactions or such transactions have been terminated for default or certain reasons related to regulatory changes. Provisions of the power supply agreements that by their terms survive terminations would expire on their original expiration dates.

 

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 generally 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 September 30, 2004, 35 retail electric providers served customers that receive transmission and distribution services from TNMP. First Choice provided electric service to customers that accounted for approximately 50 percent of the energy delivered by TNMP for the nine months ended September 30, 2004 as compared to 58 percent for the same period last year. 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 nine months ended September 30, 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. Through September 30, 2004, First Choice has reduced purchased power expense by $2.3 million for the estimated ERCOT settlement adjustment for the year ended December 31, 2003.

 

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 April 7, 2000 Merger that had a carrying value of $270.3 million as of September 30, 2004. TNP has apportioned the carrying value of the goodwill between its Regulated Transmission and Distribution segment and First Choice for purposes of evaluating carrying value. As of September 30, 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.

 

-20-


Table of Contents

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.

 

Based on the proposed transaction discussed in Note 2, management has concluded that the fair value of the goodwill related to the Merger exceeded its carrying value.

 

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.

 

Results of Operations

 

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

 

Overall Results

 

TNP had net income applicable to common stock of $11.6 million for the quarter ended September 30, 2004, compared with net income applicable to common stock of $5.0 million for the quarter ended September 30, 2003. For the nine months ended September 30, 2004, TNP had a loss applicable to common stock of $87.7 million compared with a loss applicable to common stock of $26.7 million for the nine months ended September 30, 2003. The changes in TNP’s earnings for the quarter and nine months ended September 30, 2004 are attributable to the factors listed below (in millions):

 

   

Earnings

Increase (Decrease)


 
    Three Months
Ended September 30,
2004 v. 2003


    Nine Months
Ended September 30,
2004 v. 2003


 

Change in First Choice net income (loss)

  $ 8.0     $ 46.8  

Change in TNMP net income (loss)

    (1.5 )     (104.9 )

TNP Preferred stock dividends

    (0.8 )     (2.4 )

All other and intercompany eliminations

    0.9       (0.5 )
   


 


TNP consolidated net income

  $ 6.6     $ (61.0 )
   


 


 

-21-


Table of Contents

First Choice Results

 

First Choice had net income of $14.5 million for the quarter ended September 30, 2004, compared with a net income of $6.5 million for the quarter ended September 30, 2003. For the nine months ended September 30, 2004, First Choice had net income of $29.9 million, compared with a net loss of $16.9 million for the nine months ended September 30, 2003. The changes in First Choice’s earnings for the quarter ended September 30, 2004 are attributable to the factors listed below (in millions):

 

   

Earnings

Increase (Decrease)


 
    Three Months
Ended September 30,
2004 v. 2003


    Nine Months
Ended September 30,
2004 v. 2003


 

Changes in gross profit

  $ 8.5     $ 68.5  

Other operating and maintenance

    3.5       4.9  

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

    (4.0 )     (26.6 )
   


 


Change in First Choice net income (loss)

  $ 8.0     $ 46.8  
   


 


 

First Choice Gross Profit

 

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

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

   2003

   Increase
(Decrease)


    2004

    2003

   Increase
(Decrease)


 

Operating revenues

   $ 171,877    $ 212,631    $ (40,754 )   $ 429,174     $ 544,668    $ (115,494 )

Transmission and distribution costs

     46,653      56,536      (9,883 )     123,763       158,694      (34,931 )
    

  

  


 


 

  


Operating revenues, net of transmission and distribution costs

     125,224      156,095      (30,871 )     305,411       385,974      (80,563 )

Purchased power

     89,788      125,602      (35,814 )     222,309       367,294      (144,985 )

Clawback accrual

     —        3,589      (3,589 )     (48 )     4,008      (4,056 )
    

  

  


 


 

  


Gross profit

   $ 35,436    $ 26,904    $ 8,532     $ 83,150     $ 14,672    $ 68,478  
    

  

  


 


 

  


 

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 and nine months ended September 30, 2004, compared with the same periods in 2003 (in thousands).

 

    Increase (Decrease)

 
    Three Months
Ended September 30,
2004 v. 2003


    Nine Months
Ended September 30,
2004 v. 2003


 

Price variances

               

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

  $ 6,970     $ 9,934  

Changes in competitive rates

    6,050       19,681  

Decreased purchased power expenses attributable to lower prices

    7,814       35,024  

Quantity variances

               

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

    (32,558 )     (71,575 )

Decreased purchased power expenses attributable to lower sales to customers

    38,258       110,852  

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

    (11,910 )     (37,831 )

Prior period ERCOT Settlements to purchased power expense

    (10,259 )     (891 )

Clawback Expense

    3,589       4,056  

All other

    578       (772 )
   


 


Gross profit increase

  $ 8,532     $ 68,478  
   


 


 

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Gross profit for the three and nine months ended September 30, 2004, increased $8.5 million and $68.5 million compared with the corresponding 2003 periods. The increase in both periods 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 three and nine months ended September 30, 2004, net of transmission and distribution charges, decreased $4.9 million and $27.9 million, respectively, compared to the same period in 2003. The decrease was caused by milder weather conditions in 2004 compared to 2003, and a decrease in the number of price-to-beat customers.

 

Revenues from competitive customers, net of transmission and distribution charges, decreased $26.5 million and $51.9 million for the three and nine months ended September 30, 2004, respectively, compared with the three and nine months ended September 30, 2003. Decreased sales resulting from milder weather in 2004 compared to 2003 and the net decrease in customers were primarily responsible for the decrease in revenue. The decrease in sales was partially offset by increases in rates of $6.1 million and $19.7 million for the three and nine months ended September 30, 2004, respectively, compared with the three and nine months ended September 30, 2003. Beginning in the second quarter of 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 and nine months ended September 30, 2004, First Choice incurred transmission and distribution costs related to sales to price-to-beat and competitive customers of $46.7 million and $123.8 million, compared with $56.5 million and $158.7 million for the three and nine months ended September 30, 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 for the three and nine months ended September 30, 2004 compared to the three and nine months ended September 30, 2003.

 

Purchased power expenses decreased $35.8 million and $145.0 million for the three and nine months ended September 30, 2004, respectively, compared with the amount incurred for the same period in 2003. Lower prices accounted for $7.8 million and $35.0 million of the decrease for the three and nine months ended respectively. 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 operations, giving First Choice the ability to purchase natural gas at fixed prices, thereby locking in the cost of its energy supply. An additional $38.3 million and $110.9 million of the decrease resulted from a decrease in sales during the three and nine months ended September 30, 2004 compared with the three and nine months ended September 30, 2003 as discussed above. Also, for the three months ended September 30, 2004, prior period purchased power adjustments reduced gross profit by $10.3 million, when compared to the same period last year. The third quarter of 2003 included $7.7 million of reduction to purchased power related to ERCOT’s resettlement adjustments for 2002.

 

Other Operating and Maintenance

 

Other operating and maintenance expenses for the third quarter of 2004 decreased by $3.5 million compared with the same period in 2003. For the nine months ended September 30, 2004, other operating and maintenance expenses decreased by $4.9 million compared with the same period in 2003. The decreases resulted primarily from lower bad debt.

 

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TNMP Results

 

TNMP had income applicable to common stock of $10.8 million for the quarter ended September 30, 2004, compared with income applicable to common stock of $12.3 million for the quarter ended September 30, 2003. For the nine months ended September 30, 2004, TNMP had a net loss of $76.7 million compared with income applicable to common stock of $28.2 million for the nine months ended September 30, 2003. The changes in TNMP’s earnings for the quarter and nine months ended September 30, 2004 are attributable to the factors listed below (in millions):

 

   

Earnings

Increase (Decrease)


 
   

Three Months

Ended September 30,
2004 v. 2003


   

Nine Months

Ended September 30,
2004 v. 2003


 

Changes in gross profit

  $ 1.6     $ (4.8 )

Other operating and maintenance

    (3.7 )     (4.5 )

Taxes other than income taxes

    (0.5 )     (1.6 )

Extraordinary Item (net of taxes)

    —         (97.8 )

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

    1.1       3.8  
   


 


TNMP consolidated earnings decrease

  $ (1.5 )   $ (104.9 )
   


 


 

TNMP Gross Profit

 

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

 

    

Three Months Ended

September 30,


  

Nine Months Ended

September 30,


 
     2004

   2003

  

Increase

(Decrease)


   2004

   2003

   Increase
(Decrease)


 

Operating revenues

   $ 74,732    $ 69,953    $ 4,779    $ 201,454    $ 199,079    $ 2,375  

Purchased power

     19,628      17,542      2,086      54,600      50,843      3,757  

Transmission expense

     6,329      5,257      1,072      19,001      15,616      3,385  
    

  

  

  

  

  


Gross profit

   $ 48,775    $ 47,154    $ 1,621    $ 127,853    $ 132,620    $ (4,767 )
    

  

  

  

  

  


 

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

 

The following table summarizes the components of the change in TNMP’s gross profit for the three and nine months ended September 30, 2004, compared with the same periods in 2003 (in thousands).

 

   

Earnings

Increase (Decrease)


 
    Three Months
Ended September 30,
2004 v. 2003


    Nine Months
Ended September 30,
2004 v. 2003


 

Customer growth

  $ 686     $ 1,967  

Weather/customer usage related

    796       (3,056 )

Transmission revenues, net of expenses

    (866 )     (2,477 )

Price/sales mix and other

    401       (715 )

Electric service revenues

    (431 )     (444 )

Industrial

    1,035       (42 )
   


 


Gross profit increase (decrease)

  $ 1,621     $ (4,767 )
   


 


 

Gross profit for the three months ended September 30, 2004, increased $1.6 million, or 3.4 percent compared with the corresponding 2003 period. The overall increase is driven by a $1.0 million increase in industrial revenue due to the timing of customer billings for the quarter, and by a $0.7 million increase associated with growth in customers. In addition operating

 

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revenues increased by $0.8 million, as average customer usage was slightly higher in the third quarter of 2003 versus the third quarter of 2004. Partially offsetting these increases were reductions in transmission revenues, net of expenses, of $0.9 million, resulting from an increase in expenses due to higher transmission costs from TXU Electric Delivery Company and Lower Colorado River Authority. In addition there was a $0.4 million decrease in electric service revenues due to lower disconnect and reconnect fees.

 

Gross profit for the nine months ended September 30, 2004, decreased $4.8 million, or 3.6 percent compared with the corresponding 2003 period. The overall decrease is attributed to a $3.1 million decrease in revenue due to milder weather, and to a $2.5 million increase in transmission costs from TXU Electric Delivery Company and Lower Colorado River Authority. Partially offsetting these reductions were increases in revenues of $2.0 million associated with growth in customers.

 

Purchased power expenses increased by $2.1 million and $3.8 million for the three and nine months ended September 30, 2004 compared with the amounts incurred during the same periods in 2003. Throughout 2003, TNMP recovered New Mexico purchased power costs through the fuel and purchased power adjustment clause authorized by the NMPRC. This clause expired in February 2004 resulting in $0.1 million and $0.8 million reduction to purchased power recovery revenues for the three and nine months ended September 30, 2004. As discussed in Note 3, TNMP is taking step to reinstate the New Mexico purchased power adjustment clause in the fourth quarter of 2004.

 

Operating Expenses

 

TNMP incurred operating expenses of $51.9 million for the quarter ended September 30, 2004, an increase of $7.6 million from the amount incurred during the corresponding period of 2003. For the nine months ended September 30, 2004, TNMP incurred operating expenses of $150.0 million, an increase of $14.1 million from the amount incurred during the corresponding period of 2003.

 

Operating expenses include purchased power and transmission expense. Those expenses increased by $3.2 million and $7.1 million for the three and nine months ended September 30, 2004, compared with the same periods in 2003.

 

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

 

Other Operating and Maintenance

 

Other operating and maintenance expenses increased by $3.7 million and by $4.5 million for the quarter and nine months ended September 30, 2004, compared with the same periods in 2003 respectively. The three and nine month increases are primarily attributable to a $3.1 million reduction to operating expenses in August 2003 related to the transfer of previously expensed System Benefit Fund costs from expense to a regulatory asset based on a PUCT ruling.

 

Taxes Other Than Income Taxes

 

Taxes other than income taxes increased $0.5 million and $1.6 million for the three and nine months ended September 30, 2004, compared with the corresponding periods in 2003. The increase is primarily related to higher ad valorem taxes.

 

Extraordinary Item (net of taxes)

 

In the second quarter of 2004, TNMP recorded a loss of $97.8 million related to the PUCT true-up proceeding regarding TNMP’s stranded costs. The PUCT allowed TNMP to recover $87.3 million of the $266.5 million that TNMP requested as stranded cost. This decision resulted in a loss of $155.2 million before tax ($97.8 million after tax). TNMP recorded the $97.8 million after tax loss as an extraordinary item.

 

TNP Preferred Stock Dividends

 

Dividends on preferred stock increased $0.8 million and $2.4 million for the three and nine months ended September 30, 2004, respectively, compared with the corresponding periods in 2003. The increases are attributable to TNP paying dividends on preferred stock through the issuance of additional shares of preferred stock.

 

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Financial Condition

 

TNP Liquidity

 

TNP’s main sources of liquidity, and its ability to service its debt, has depended 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.

 

For the nine months ended September 30, 2004, TNP’s consolidated cash flow from operations was $66.7 million higher than in the nine months ended September 30, 2003. The factors causing the increase in cash flow from operations are summarized in the following table (in millions).

 

     Cash Flow
Increase(Decrease)


 
     Nine Months
Ended September 30,
2004 v. 2003


 

Cash paid in 2003 for natural gas options

   $ 19.6  

Increased cash flow from sales, net of purchased power payments

     28.5  

Decreased cash paid to suppliers

     20.3  

All other

     (1.7 )
    


TNP consolidated cash flow from operations

   $ 66.7  
    


 

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 purchasing strategy 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 decreased payments to suppliers are primarily attributable to decreased transmission and distribution charges due to lower sales in 2004.

 

Stranded Cost Disallowance. As discussed in Note 3, in the second quarter of 2004 TNMP recorded an extraordinary loss of $97.8 million related to the PUCT true-up proceeding regarding TNMP’s stranded costs. The loss did not trigger any covenant violations at TNP or TNMP.

 

As a result of the extraordinary charge, TNMP’s equity balance is currently 28 percent of its total capitalization. Due to the reduction in TNMP’s equity balance, management does not currently expect TNMP to pay dividends to TNP. Management believes that dividends from First Choice, payments under the tax sharing agreement, and cash on hand should be sufficient to meet TNP’s working capital requirements through the end of 2005.

 

Rating Actions. In June 2004, as a result of the PUCT true-up order, Moody’s downgraded TNP’s senior unsecured debt to B1 from Ba2, TNP’s subordinated debt to B2 from Ba3 and TNP’s preferred stock to B3 from B1. Also in June, Standard & Poor’s placed TNP’s ratings on credit watch negative, primarily as a result of the PUCT true-up order. In July 2004, Fitch downgraded TNP’s senior secured bank facility to B+ from BB, TNP’s senior subordinated notes to B from BB- and TNP’s preferred stock to CCC from B+, with a rating outlook of negative. Fitch cited the PUCT true-up order and weaker than expected 2004 results from FCP. TNP has no financial covenants or regulatory restrictions that are affected by the recent rating actions.

 

Subsequent to the announcement that PNM Resources has agreed to acquire TNP, Moody’s and Fitch revised their ratings outlook on TNP and TNMP to positive from negative, and Standard & Poor’s revised its rating outlook on TNP and TNMP to developing from negative.

 

First Choice Liquidity

 

First Choice Liquidity. 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 operations. As a result, First Choice has secured supply to serve most of its forecasted commitments to existing competitive customers for 2004 at fixed prices. In addition, First Choice has fixed the price of energy for forecasted commitments to price-to-beat customers through December 2004.

 

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First Choice 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 ended on June 1, 2004. On that date, phase three commenced and First Choice transferred all of First Choice’s customers and receivables into a bankruptcy remote subsidiary, First Choice Power Special Purpose, LP (SPE), which operates as a retail electric provider, as discussed in Note 3. First Choice took this action to comply with the PUCT order issued on March 16, 2004 that authorized the transfer of customers to the SPE.

 

The SPE holds all customer contracts and wholesale power and natural gas contracts previously held by First Choice. Constellation received a lien against the assets of SPE, including billed and unbilled receivables, all cash of the SPE, customer contracts, and the equity of the SPE, to cover the settlement exposure and mark-to-market exposure rather than requiring the SPE to post alternate collateral for purchase power supply. In addition, the SPE is restricted by covenants that limit the size of the SPE’s unhedged market positions and require that sales by the SPE retain a positive retail margin. The agreement does not, however, permit Constellation to demand additional collateral irrespective of its credit exposure under the agreement. If, however, a change in electricity or gas forward prices increases Constellation’s credit exposure to the SPE beyond a limit based on Constellation’s liens in cash and accounts receivable, Constellation will have no obligation to supply additional customers of the SPE unless the SPE provides letters of credit or other collateral acceptable to Constellation, and the SPE will be constrained in its ability to sign up additional customers until that credit shortfall is corrected. In connection with the formation of the SPE, Constellation released TNMP from its $25 million guarantee of certain power supply obligations of First Choice.

 

Phase three commitments to supply power for new customers will continue until December 31, 2006, although Constellation has agreed to supply power in certain transactions under the agreement beyond the date when that commitment expires. The SPE may terminate the agreement upon thirty days prior notice to Constellation, for any reason, but the agreement and all liens securing the agreement remain in effect with respect to transactions entered into prior to the termination, until both parties have fulfilled all of their obligations with respect to such transactions or such transactions have been terminated for default or certain reasons related to regulatory changes. Provisions of the power supply agreements that by their terms survive terminations would expire on their original expiration dates.

 

Management believes that First Choice’s cash flow from operations and cash on hand should be sufficient to meet First Choice working capital and credit needs and provide dividends to TNP through the end of 2005.

 

TNMP Liquidity

 

Affiliate 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. On June 1, 2004, TNMP terminated this authority to guarantee the power supply obligations of First Choice upon First Choice’s establishment of FCPSP under authorization granted by the PUCT in Docket No. 29081. FCPSP has been established in connection with First Choice’s power supply agreement with Constellation.

 

Stranded Cost Disallowance. As discussed in Note 3, in the second quarter of 2004, TNMP recorded an extraordinary loss of $97.8 million related to the PUCT true-up proceeding regarding TNMP’s stranded costs. The loss did not trigger any covenant violations at TNMP.

 

Debt Repurchases. During the first six months of 2004, TNMP repurchased $7.3 million of its 6.25 percent Senior Notes due in 2009 and $1.1 million of its 6.125 percent Senior Notes due in 2008. There were no additional debt repurchases in the third quarter of 2004.

 

Rating Actions. In June 2004, as a result of the PUCT true-up order, Moody’s downgraded TNMP to Ba2 from Baa3, and identified the ratings outlook as negative. Also in June, Standard & Poor’s placed TNMP’s ratings on credit watch negative, primarily as a result of the PUCT true-up order. In July 2004, Fitch downgraded TNMP from BB+ to BB with a rating outlook of negative, primarily as a result of the PUCT true-up order. TNMP has no financial covenants or regulatory restrictions that are affected by the recent rating actions.

 

Subsequent to the announcement that PNM Resources has agreed to acquire TNP Enterprises, Moody’s and Fitch revised their ratings outlook on TNP and TNMP to positive from negative, and Standard & Poor’s revised its rating outlook on TNP and TNMP to developing from negative.

 

Cash Flow. Management believes that TNMP’s cash flow from operations and cash on hand should be sufficient to meet TNMP working capital and credit needs through the end of 2005.

 

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Item 4. Controls and Procedures.

 

As of September 30, 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 September 30, 2004.

 

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PART II - OTHER INFORMATION

 

Item 1. Legal Proceedings

 

See Notes 3 and 9 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: None

 

Statement Regarding Forward Looking Information

 

The discussions in this document that are not historical factors, 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 outcome of any appeals of the PUCT order in the stranded cost true-up proceeding; the results of any future regulatory proceedings including the inclusion of the clawback liability in a rate adjustment proceeding; the outcome of efforts to re-establish the New Mexico FPPCAC; the payment of dividends by TNMP, First Choice or the FCPSP; 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; 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. These factors include risks and uncertainties relating to the receipt of regulatory approvals of the proposed acquisition of TNP by PNM Resources, Inc. (the “PNM Transaction”), the risks that the businesses will not be integrated successfully, the risk that the benefits of the PNM Transaction will not be fully realized or will take longer to realize than expected, the risk that TNP debt and preferred retirements will not occur as expected, that the businesses will not be integrated successfully, and that disruption from the PNM Transaction making it more difficult to maintain relationships with customers, employees, suppliers or other third parties, additional factors include conditions in the financial markets relevant to the proposed transaction, interest rates, weather, fuel costs, changes in supply and demand in the market for electric power, wholesale power prices, market liquidity, the competitive environment in the electric and natural gas industries, state and federal regulatory and legislative decisions and actions, the outcome of legal proceedings and the performance of state, regional and national economies; 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: November 3, 2004

 

By

 

\s\ WILLIAM J. CATACOSINOS


       

William J. Catacosinos

       

Chief Executive Officer

Date: November 3, 2004

 

By

 

\s\ THEODORE A. BABCOCK


       

Theodore A. Babcock

       

Chief Financial Officer

 

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