ITEM 1. BUSINESS
GENERAL
Marine Drilling Companies, Inc. (collectively with its subsidiaries, the "Company") was incorporated in Texas in January 1990. Since 1966, the Company or its predecessors has been engaged in offshore contract drilling of oil and gas wells for independent and major oil and gas companies. As of March 6, 1995, the Company owned and operated a fleet of thirteen mobile offshore jack-up drilling rigs, consisting of four independent leg cantilever jack-ups and nine mat supported jack-ups. On that date, eleven of the Company's thirteen rigs were located in the U.S. Gulf of Mexico, one was in the Bay of Campeche and one was in transit to the U.S. Gulf of Mexico from Southeast Asia. The Company currently derives substantially all of its revenues from offshore drilling in the U.S. Gulf of Mexico and in the Bay of Campeche. The Company's rigs could, with certain modifications, work in other areas, however, the Company's rigs are not suitable for those areas, such as the North Sea, that require hostile environment operating capabilities.
The Company's strategy is to strive to maintain its position as a significant provider of offshore drilling services in its present markets and to continue to diversify, insofar as financially and operationally practicable, into other international offshore drilling markets. The Company also intends to seek business combinations and to make acquisitions of additional drilling rigs which, over the long term, the Company believes will benefit its shareholders.
The Company was significantly restructured and recapitalized in 1992 and early 1993 (the "Recapitalization"). See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations -- The Recapitalization" for further information.
INDUSTRY CONDITIONS AND COMPETITION
Demand for offshore drilling services is primarily driven by the economics of oil and gas exploration, development and production, which in turn, are closely tied to oil and gas prices. Since the mid-1980's oil and gas prices have been volatile and generally lower than prices experienced during the early 1980's. As a result, demand for offshore drilling services has been volatile and generally lower than during the early 1980's. In addition, during the late 1970's and early 1980's, the industry built a substantial number of new offshore drilling rigs. The combination of (i) generally lower oil and gas prices, (ii) increased rig supply and (iii) lower demand for offshore drilling services has resulted in many periods of depressed pricing and utilization for most of the world's offshore drilling markets.
Pricing and rig water depth capabilities are generally the most important competitive factors in the drilling industry. Other competitive factors include the technical capabilities of specialized drilling equipment and personnel, operational experience, rig suitability, efficiency, equipment condition, safety record, reputation and customer relations. The Company believes that it competes favorably with respect to these factors.
The magnitude of the Company's contract drilling revenues is dependent upon rig utilization and pricing. These variables are affected by competitive conditions and the amount of exploration and development activity conducted by oil and gas companies. As previously stated, this activity is strongly influenced by the current and projected prices of oil and natural gas. To provide a recent historical perspective, oil and gas prices for 1990 through 1994 are set forth in the following graph:
OIL AND NATURAL GAS PRICES
[GRAPH]
Five year history of Oil and Natural Gas Prices by quarters from January 1, 1990 through December 31, 1994.
Source: Offshore Data Services Natural Gas Prices -- Offshore Louisiana Spot Gas Oil Prices -- West Texas Intermediate
Worldwide Offshore Market Conditions
As the following graph illustrates, from the beginning of 1992 to the end of 1994, the number of jack-up rigs available worldwide has declined only slightly (approximately 2.5%). Jack-up rig demand during that period has varied from a low of 257 rigs (64% utilization) during the second quarter of 1992 to a high of 312 rigs (80% utilization). During 1994, the average worldwide supply, demand and utilization of jack-up rigs was 391, 296 and 75%, respectively, as compared to 1993 during which these statistics were 393, 308 and 78%, respectively. Although it would appear that the small variance between the statistics for 1994 and 1993 might imply a minimal decrease in day rates in 1994, other trends emerge due to the mobile nature of jack-up rigs. As discussed later in this section, there was a significant movement of jack-up rigs during 1993 and 1994 into the U.S. Gulf of Mexico from other worldwide drilling markets. These mobilizations generally occurred for two reasons -- (i) strong natural gas prices throughout 1993 and early 1994 led to increased demand for jack-ups in the U.S. Gulf of Mexico and (ii) oil prices were generally weak during the latter half of 1993 and the first quarter of 1994 which had a depressing effect on the demand for drilling services in many jack-up markets outside the U.S. Gulf of Mexico.
The following graph includes data regarding worldwide jack-up rig supply (including non-marketed rigs), demand and utilization for 1992 through 1994:
WORLDWIDE JACK-UP RIG STATISTICS
[GRAPH]
Statistics for Jack-Up Rigs Worldwide consisting of the total rigs, working rigs, and rig utilization by quarters from January 1, 1992 through December 31, 1994.
Source: Offshore Data Services
Due to the extremely competitive nature of the offshore drilling business, changes in the demand for drilling services among different markets cause many drilling contractors to react by moving several rigs away from their weaker markets to stronger markets, thereby creating an increased supply of rigs in the stronger market. This increased rig supply in the stronger market will quickly cause day rates to deteriorate unless rig demand increases at or above the rate of growth in rig supply. It seems that the participants in the offshore drilling industry often have a tendency to move too many rigs into the stronger market -- causing it to suffer utilization and day rate deterioration. The tendency of the offshore drilling industry to "over-mobilize" rigs among markets has been exacerbated by the volatile nature of oil and gas prices since the mid-1980's. As the prices of these commodities fluctuate, oil and gas companies quickly adjust their drilling budgets to reflect the changed economics of exploration and production. Thus, a drilling market which is driven primarily by the exploration and production of only one of those commodities will generally see a change in the demand for drilling services triggered by the change in the price of the underlying commodity. These changes in demand for drilling services often occur quickly and can have significant magnitude. For example, the weak price of natural gas during most of 1991 and early 1992 had a significant depressing effect on jack-up demand during 1991 and early 1992.
During the periods discussed herein, the Company operated primarily in the U.S. Gulf of Mexico and the Bay of Campeche, offshore Mexico. These markets are further discussed below. The profitability of offshore drilling in these markets, as well as most of the world's offshore drilling markets, has been volatile since the mid-1980's and is expected to remain volatile until the supply of jack-up rigs and demand therefor move closer to equilibrium levels. The Company is unable to predict future oil and gas prices or future levels of offshore drilling activity.
U.S. Gulf of Mexico
The following graphs illustrate the relationship among working jack-up rigs, jack-up rig utilization and jack-up rig supplies based upon all rigs, as well as "marketed" rigs.
U.S. GULF OF MEXICO JACK-UP RIG STATISTICS -- ALL RIGS
[GRAPH]
Statistics for Jack-Up Rigs in the U.S. Gulf of Mexico consisting of the total rigs, working rigs, and rig utilization by quarters from January 1, 1992 through December 31, 1994.
Source: Offshore Data Services
U.S. GULF OF MEXICO JACK-UP RIG STATISTICS -- MARKETED RIGS
[GRAPH]
Statistics for marketed Jack-Up Rigs in the U.S. Gulf of Mexico consisting of the marketed rigs, working rigs, and rig utilization by quarters from January 1, 1992 through December 31, 1994.
Source: Offshore Data Services
The jack-up drilling market in the U.S. Gulf of Mexico is highly competitive. A significant number of offshore drilling companies have rigs in this market and, as a result, no one contractor is able to materially affect pricing levels. Indeed, day rates can and have exhibited major changes on relatively small changes in the rig supply and demand situation in this market.
As illustrated in the preceding graphs, since 1992, demand for jack-up rigs in this market has shown general improvement. Day rates during this period generally increased until late 1993, however, they began to decline thereafter. The decline in day rates during 1994 was due primarily to the supply of marketed jack-up rigs growing faster than the rate of growth of jack-up rig demand. The "Marketed Rigs" graph illustrates the variance in the growth in the supply of marketed rigs versus working rigs. As noted on that graph, during 1992, 1993 and 1994, the average utilization of marketed rigs was approximately 71%, 90% and 81%, respectively. The growth in the marketed jack-up rig supply was due to two factors -- (i) net rig mobilizations into this market and (ii) reactivations (primarily during 1993) of previously noncompetitive rigs.
In late 1994 and early 1995, the price of natural gas continued to deteriorate due to a mild winter in the U.S. As a result, jack-up rig demand in the U.S. Gulf of Mexico has shown a significant decline since year-end 1994. According to Offshore Data Services, as of February 28, 1995, there were 141 jack-up rigs in the U.S. Gulf of Mexico of which 90 were contracted (a 64% utilization rate). Day rates during early 1995 have also deteriorated and may decline further. Moreover, as previously discussed, jack-up rigs are mobile and competitors could move additional rigs from other markets to the U.S. Gulf of Mexico. In addition, there are additional non-marketed rigs stacked in the U.S. Gulf of Mexico which, subject to some expenditure, have been or could be reactivated. Such movement or reactivation could further depress pricing levels.
Bay of Campeche, Offshore Mexico
BAY OF CAMPECHE JACK-UP RIG STATISTICS
[GRAPH]
Statistics for Jack-Up Rigs in the Bay of Campeche, Offshore Mexico, consisting of the total rigs, working rigs, and rig utilization by quarters from January 1, 1992 through December 31, 1994.
Source: Offshore Data Services
The Bay of Campeche drilling market experienced rapid growth in rig demand during the period from late 1992 to mid-1993. Since that time, the market has shown general deterioration. The Company was able to contract two of its rigs (the MARINE 301 and MARINE 303) into this market in late 1992 and another in mid-1993. The first two rigs completed their contracts in late 1993 and early 1994, respectively, and subsequently returned to the U.S. Gulf of Mexico. The third rig (the MARINE 300) continues to operate in this market at the present time pursuant to extensions of the initial contract. The Company currently expects that contract to expire in June 1995 and intends, if no additional jobs are available in this market at that time, to mobilize that rig to the U.S. Gulf of Mexico or other international markets.
All of the rigs in the Bay of Campeche are performing drilling services for Petroleos Mexicanos ("Pemex"), the national oil company of the Republic of Mexico. Of the rigs working for Pemex in the Bay of Campeche, some are subject to contracts between the respective drilling contractors and Pemex and the other rigs are working for turnkey companies which, in turn, have entered into turnkey drilling contracts with Pemex. The MARINE 300 is contracted to Industrial Perforadora, S.A. de CV ("IPC") which, in turn, is supplying the rig and its services to Pemex pursuant to a contract between Pemex and IPC.
Recently, Mexico's currency, the peso, has suffered a significant devaluation. If this devaluation were to adversely affect Pemex's drilling programs, the demand for jack-up rigs in this market could further deteriorate. The Company is unable at this time to predict the effect of this occurrence on the Company's operations.
The following table sets forth certain industry and Company historical data for the periods indicated:
(1) Average of weekly data published by Offshore Data Services.
(2) The numbers included in the table represent the average number of rigs (rounded to the nearest whole number) operated by the Company for the periods indicated.
(3) From January 1 to March 12, 1990, the Company operated 16 rigs. In March 1990, the Company acquired four additional rigs and assumed charter agreements covering three additional rigs. The Company's rig fleet was substantially reduced during 1991 and 1992. See Item 2

ITEM 2. PROPERTIES
RIG FLEET
All of the Company's rigs are jack-up rigs, which are mobile self-elevating drilling platforms equipped with legs that can be lowered to the ocean floor until a foundation is established to support the drilling platform. The Company owns and operates thirteen rigs, nine of which are mat supported rigs (i.e., they have a lower hull attached to the rig legs) and four are of independent leg design. Five of the mat supported rigs and one of the independent leg rigs are slot type jack-up units which are configured for the drilling operations to take place through a slot in the hull. The Company's other four mat supported rigs and three of the independent leg rigs have a cantilever feature which allows the extension of the drilling equipment over a customer's platform to perform development drilling or workover operations. The Company's rigs are currently capable of drilling to depths of 20,000 to 30,000 feet in maximum water depths ranging from 200 to 300 feet. Three of the Company's rigs are presently configured to work in international markets outside the U.S. Gulf of Mexico. The Company's other rigs could, if applicable modifications were made and certifications obtained, operate in certain non-hostile areas outside of their current markets. The Company believes that all of its rigs are in good operating condition and have been well maintained.
[PICTURE]
Mat Supported Rig -- This type of rig consists of a floating upper hull with three legs which are attached to a lower hull commonly referred to as a mat. After being towed to the drilling location, the legs are lowered until the mat contacts the seabed and the upper hull is jacked to the desired elevation above sea level. One advantage of mat supported rigs is the ability to operate in areas having soft seabed conditions where independent leg rigs are prone to have excessive penetration and subject to leg damage.
Independent Leg Rig -- This type of rig consists of a floating hull with three independent elevated legs. After being towed to the drilling location, the legs are lowered until they penetrate the seabed and the hull is jacked to the desired elevation above sea level.
[PICTURE]
The following table describes the Company's drilling rigs as of February 24, 1995:
(a) Can be modified to provide for 300 foot water depth capacity. (b) Designed to operate in environmentally sensitive areas such as Mobile Bay. (c) Equipped with top drive drilling system. (d) Configured for international operations. (e) Year of construction -- 1976 (f) In transit from Singapore to the U.S. Gulf of Mexico (g) Year of construction -- 1969 * Friede & Goldman. ** Marathon LeTourneau
The Company's fleet was substantially reduced in 1991 and 1992, during which the Company reduced the number of rigs from twenty-one to eleven. See Item 7 " -- The Recapitalization." In August 1993, the Company acquired and refurbished the MARINE 304. Later in 1993, the Company refurbished and reactivated the MARINE 225 (previously named the MARINE 1). During the fourth quarter of 1994, the Company acquired the MARINE 3 (which the Company had chartered from its former owner since early 1993) for approximately $5,500,000. In addition, the Company acquired the MARINE 201 in December 1994 for approximately $7,000,000.
OTHER PROPERTY
The Company leases approximately 28,000 square feet of office space in Sugar Land, Texas for its headquarters. Due to the pending expiration of this lease in May 1995, the Company has leased approximately 19,000 square feet in an office building in Sugar Land and plans to move thereto in April 1995. In addition, the Company leases a warehouse, storage and repair facility, including approximately 31 acres of land and 60,000 square feet of buildings, in Rosharon, Texas (near Houston).
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
GENERAL
Various claims have been filed against the Company and its subsidiaries in the ordinary course of business, particularly claims alleging personal injuries. Management believes that the Company has established adequate reserves for any liabilities which may reasonably be expected to result from these claims. In the opinion of management, no pending claims, actions or proceedings against the Company or its subsidiaries are expected to have a material adverse effect on its financial position or results of operations.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
The Company's common stock, par value $.01 per share (the "Common Stock"), trades on the Nasdaq Stock Market under the symbol "MDCO." The following table sets forth the range of high and low sale prices per share of the Common Stock as reported by the Nasdaq Stock Market for the periods indicated.
The last sale price of the Common Stock as reported by the Nasdaq Stock Market on March 6, 1995 was $2 5/8 per share and there were approximately 500 holders of record.
The Company has not paid cash dividends on its Common Stock in the past and does not intend to pay dividends on the Common Stock in the foreseeable future. See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and Notes thereto included in Item 8 of this report.
ITEM 6.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table sets forth selected consolidated financial data of the Company as of and for each of the periods indicated. The selected financial data for each of the five years in the period ended December 31, 1994 are derived from the Company's audited consolidated financial statements. The information presented below should be read in conjunction with Item 7

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION -- GENERAL
The following is a discussion of the Company's financial condition, results of operations, historical financial resources and working capital. This discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto included in Item 8

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders Marine Drilling Companies, Inc.:
We have audited the consolidated financial statements of Marine Drilling Companies, Inc. and subsidiaries as listed in Item 14 on page 44. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in Item 14 on page 44. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Marine Drilling Companies, Inc. and subsidiaries as of December 31, 1994 and 1993, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1994, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
KPMG PEAT MARWICK LLP
Houston, Texas February 3, 1995
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
See notes to consolidated financial statements. MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT SHARE DATA)
See notes to consolidated financial statements. MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE DATA)
YEARS ENDED DECEMBER 31, 1994, 1993 AND 1992
See notes to consolidated financial statements. MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
[Continued]
See notes to consolidated financial statements. MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS -- (CONTINUED) (IN THOUSANDS, EXCEPT SHARE DATA)
See notes to consolidated financial statements. MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1994, 1993 AND 1992 (IN THOUSANDS, EXCEPT SHARE DATA)
(1) BASIS OF PRESENTATION AND RECAPITALIZATION TRANSACTIONS
Basis of Presentation
References herein to the "Company" refer to Marine Drilling Companies, Inc. ("Parent") and its wholly-owned subsidiaries, Marine Drilling Management Company ("MDMC"), Keyes Holding Corporation ("KHC") and Marine Drilling International, Inc. unless the context otherwise requires a reference only to the Parent.
Recapitalization Transactions
On June 19, 1992, the Company entered into an agreement with certain of its lenders and preferred shareholders providing for a significant recapitalization ("Recapitalization"). On June 19, 1992, $500 was paid to one of the lenders in exchange for the discharge of approximately $13,942 of bank indebtedness. On October 29, 1992, the Recapitalization was approved by the Company's shareholders and, as a result, the Company's debt (including interest) and preferred stock obligations were reduced during 1992 by approximately $187,000 and the Company's rig fleet was substantially reduced. The Recapitalization included a one-for-twenty-five reverse split of the Company's $.10 par value common stock into $.01 par value common stock ("Common Stock").
In connection with the approval of the Recapitalization, the Company's remaining bank indebtedness and related interest totalling approximately $51,919 as of September 30, 1992 was completely discharged for approximately 5,000,000 shares of Common Stock which were issued to a group of the Company's lenders. The Recapitalization also included the reclassification of the Company's 14% cumulative exchangeable preferred stock, par value $1.00 per share ("Old Preferred Stock") with a liquidation preference as of October 29, 1992 of approximately $65,582 into 19,369,893 shares of Common Stock.
The Company sold 9,638,214 shares of Common Stock of which 4,800,000 shares were purchased by three of the Company's principal shareholders pursuant to a rights offering ("Rights Offering"). The Rights Offering was closed in December 1992 with the Company receiving net proceeds of approximately $11,537.
As part of the Recapitalization, the Company entered into a $4,000 bridge loan facility with three of its principal shareholders which was intended to fund the Company's operations through the completion thereof. On October 29, 1992, the $4,000 principal amount and interest thereon were exchanged for shares of Common Stock at an exchange price of $1.25 per share.
During 1992 the Company defaulted on all series of its U.S. Government guaranteed Title XI ("Title XI") ship financing bonds owed by two of its subsidiaries. The Company transferred custody and financial responsibility for seven of its eight Title XI financed rigs to the Maritime Administration of the United States Department of Transportation ("MarAd"), agreed to pay to MarAd certain additional amounts in connection with certain litigation (see below), proposed to restructure approximately $2,300 in debt and pay approximately $460 in consideration for the discharge of approximately $63,019 in debt and related interest. In September 1992, some of the Company's subsidiaries and MarAd entered into an agreement (the "Storm Drilling Restructuring"). MarAd agreed to (i) release one of the subsidiaries from its limited guarantee of interest on another subsidiary's Title XI debt, (ii) not to take adverse actions against the Company or its other subsidiaries or affiliates with respect to any deficiencies remaining on the Title XI debt after the foreclosure or sale of the subsidiary's rigs and (iii) take custody of the subsidiary's rigs. In addition to the foregoing, MDMC paid approximately $3,802 to MarAd from litigation involving the MARINE 7.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Quasi-Reorganization
On December 31, 1992, the Company adopted quasi-reorganization accounting procedures. Quasi-reorganization accounting allowed the Company to eliminate the accumulated deficit against additional paid-in capital and to revalue assets and liabilities to estimated fair values. Therefore, the adoption of quasi-reorganization accounting procedures following the Recapitalization gave the Company a "fresh start" for accounting purposes.
The adoption of quasi-reorganization accounting procedures resulted in a decrease to property and equipment of $56,051, a decrease in assets held for sale of $240, a decrease in other assets of $9,043, a decrease in debt of $8,054, a decrease in deferred expenses of $145, a decrease in receivables of $112 and an increase in other liabilities of $25.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OPERATIONS
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.
Operations
As of December 31, 1994, the Company's fleet consisted of 13 jack-up rigs.
Property and Equipment
Property and equipment are stated at historical cost or the cost assigned to the assets at December 31, 1992 in connection with the adoption of quasi-reorganization accounting procedures. Depreciation is provided on the straight-line method over the estimated remaining useful lives of the assets which are as follows:
Maintenance and repairs amounted to $8,600, $8,030 and $1,943 in 1994, 1993 and 1992, respectively. Expenditures for major renewals and betterments are capitalized. Expenditures for normal maintenance and repairs are charged to expense as incurred. When property or equipment is retired, the related assets and accumulated depreciation are removed from the accounts and a gain or loss is reflected in other income (expense). The Company continues to depreciate idle drilling equipment using the same rates as while operating.
Employer's Liability Claims
Employer's liability claims, principally arising from actual or alleged personal injuries, are estimates of the Company's liabilities for such occurrences. These claims are classified as current or long-term based upon the periods in which such claims are expected to be funded.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Deferred Financing Costs
Deferred financing costs are amortized over the life of the related debt. Deferred financing costs were $228 at December 31, 1994. Deferred financing costs in 1992 of $1,003 were eliminated at December 31, 1992 in connection with the adoption of quasi- reorganization accounting procedures or were written off in connection with early extinguishments of debt.
Income Taxes
In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Statement 109 required a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
Effective December 31, 1992, in conjunction with the adoption of quasi-reorganization accounting procedures, the Company adopted Statement 109. The change in the method of accounting for income taxes had no cumulative effect on the 1992 consolidated statements of operations. Pursuant to the deferred method under APB Opinion 11, which was applied during 1992 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates.
Revenue Recognition
Drilling revenues are recorded pursuant to day rate contracts, under which the Company receives a fixed amount per day for providing drilling services using the rigs it operates.
Cash Equivalents
Cash equivalents of $18,531 and $21,396 at December 31, 1994 and 1993, respectively, consist of loan participations, Eurodollar investments, mortgage backed and corporate debt securities. Their carrying value is a reasonable approximation of their fair value. For purposes of the statement of cash flows, the Company generally considers all investments with an original maturity of three months or less at date of purchase and other highly liquid investments readily convertible to determinable amounts of cash, excluding restricted cash investments, to be cash equivalents.
Short-Term Investments
Short-term investments consist of corporate debt securities, mortgage-backed securities and corporate paper. The Company classifies its short-term investments as held-to-maturity securities. Held-to-maturity securities are those securities in which the Company has the ability and intent to hold the security until maturity. Held-to-maturity securities are recorded at amortized cost, adjusted for the amortization or accretion of premiums or discounts. Premiums and discounts are amortized or accreted over the life of the related held-to-maturity security as an adjustment to yield using the effective interest method. Dividend and interest income are recognized when earned. The fair value of the short-term investments at December 31, 1994 was $18,133.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Income (Loss) Per Common Share
Income (loss) per common share is based on the weighted average number of common shares outstanding and common stock equivalents, if dilutive. For the year ended December 31, 1992, the net income (loss) applicable to common shareholders has been adjusted to reflect the dividends on and the accretion of discount on Old Preferred Stock. Net income per common share for the years ended December 31, 1994 and 1993 do not include the effect of outstanding stock options as the potential dilution from their exercise is less than three percent.
Reclassification of Accounts
Certain reclassifications have been made to the 1993 and 1992 consolidated financial statements to conform with the current presentation.
Concentrations of Credit Risk
The market for the Company's services and products in the offshore oil and gas industry, and the Company's customers consist primarily of independent and major oil and gas companies. The Company performs ongoing credit evaluations of its customers and obtains collateral security as deemed prudent. The Company has established an adequate allowance for bad debts, and such losses have been within management's expectations (see Note 9).
At December 31, 1994 and 1993, the Company had cash deposits concentrated primarily in one major bank. In addition, the Company had certificates of deposits, commercial paper and Eurodollar time deposits with a variety of companies and financial institutions with strong credit ratings, and such securities are held until maturity. The Company believes that credit and market risk in such instruments is minimal.
(3) PROPERTY AND EQUIPMENT
Property and equipment are stated at historical cost or the cost assigned to the assets at December 31, 1992 in connection with the adoption of quasi-reorganization accounting procedures, and are summarized as follows:
Depreciation expense was $7,733, $5,312 and $11,030 for the years ended December 31, 1994, 1993 and 1992, respectively. The Company rents drilling rigs, certain equipment and other property under operating leases. Rental expense was $1,707, $936 and $1,013 in 1994, 1993 and 1992, respectively.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(4) ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses are summarized as follows:
(5) LONG-TERM DEBT
Long-term debt is summarized as follows:
KHC - Note Payable to Lender
On December 1, 1994, KHC entered into a $35,000 revolving/term loan agreement (the "Loan") with a U.S. financial institution ("Lender"). As of December 31, 1994, the related debt outstanding was $15,000 and the amount of unused line of credit subject to the Loan was $20,000. Loan proceeds may be used to purchase additional jack-up drilling rigs or to make capital improvements to the Company's existing drilling rig fleet. The Company is a guarantor for up to an aggregate of $8,750 under the Loan. On June 1, 1996, all amounts borrowed under the Loan may be converted to a term loan.
If converted, the term loan will be due in thirty-six (36) consecutive monthly installments, beginning July 1, 1996 and ending June 1, 1999 amortizing at the rate of 20% of the term loan balance per year with the remaining 40% principal balance due and payable concurrently with the last payment. KHC must maintain a minimum borrowing of $10,000 (the "minimum borrowing") on the Loan after June 1, 1996. If the Company's average borrowings under the revolving loan or the term loan are less than the minimum borrowing, KHC will be required to pay a non-utilization fee of 2% of the difference between the actual average borrowed balance and the minimum borrowing. The term loan may be prepaid at any time after the eighteenth payment (December 1, 1997). A prepayment premium of 1% of the prepaid principal amount will be due with each such prepayment. Repayments may not be re-borrowed during the term loan period.
Interest is due monthly on the outstanding principal balance at the London Interbank Offered Rate ("LIBOR") plus 2.5%. The interest rate as of December 31, 1994 was 7.938%. A revolving loan fee is due quarterly during the revolving loan period based on the unused credit facility at .25%.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The note is secured by a first preferred fleet mortgage on the MARINE 300, 301 and 303 drilling rigs. The three drilling rigs must be appraised on the term loan conversion date, June 1, 1996. The term loan will be limited to 50% of the appraised value of the rigs. The Company and KHC are required to comply with various covenants, including, but not limited to, the maintenance of financial ratios related to (i) debt to total equity and (ii) working capital to fixed expenses and projected debt services.
Interest payments on the loan amounted to $70 for the year ended December 31, 1994, including a revolving loan fee of $5. A facility fee of $175 was paid to the lender during the fourth quarter 1994 and will be amortized over the life of the loan.
The scheduled repayment of long-term debt as of December 31, 1994 is as follows:
(6) INCOME TAXES
Income taxes consist of the following:
As a result of the adoption of quasi-reorganization accounting procedures on December 31, 1992, the tax effect of the realization of tax attributes generated prior thereto are recorded directly to shareholders' equity and are not reflected as a reduction of income tax expense.
For the years ended December 31, 1994 and 1993, the effective tax rate for financial reporting purposes approximates the U.S. federal statutory rate of 35%.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1994 and 1993 are presented below.
The valuation allowance for deferred tax assets as of December 31, 1994 and 1993 was $38,649 and $42,209, respectively. The net change in the total valuation allowance for the years ended December 31, 1994 and 1993 was a decrease of $3,560 and an increase of $2,615, respectively. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon projections for future taxable income over the periods which the deferred tax assets are deductible and the Section 382 limitation as discussed below, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the existing valuation allowances at December 31, 1994.
At December 31, 1994, the Company had net operating loss carryforwards for federal income tax purposes of $82,296 which are available to offset future federal taxable income, if any, through 2007. The Company also had investment tax credit and general business credit carryforwards for federal income tax purposes of approximately $13,410 (including $1,844 which are subject to the limitation as to their use imposed in connection with the 1989 Ownership Change as discussed below) at December 31, 1994 which are available to reduce future federal income taxes, if any, through 2000.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company has taken the position that the Recapitalization did not cause an ownership change under Section 382 of the Internal Revenue Code of 1986, as amended ("Code"). The Company's position is based on the applicability of Section 382(l)(3)(C) of the Code, which provides generally that any change in the proportionate ownership attributable solely to fluctuations in relative fair market value of different classes of stock are not to be taken into account for purposes of Section 382. To date, neither the Internal Revenue Service nor the United States Department of Treasury has established any rules or guidance as to how such Section will be interpreted or applied to situations similar to the Recapitalization. Accordingly, there can be no assurance that an ownership change for purposes of Section 382 will not be deemed to have occurred as a result of the Recapitalization. If an ownership change were deemed to have occurred, the utilization of the Company's net operating losses, against its future income, if any, would be limited annually to approximately $1,500. Since such limitation would be less than the Section 382 limitation (approximately $9,000) imposed as a result of the Company's 1989 sale of Common Stock which resulted in an ownership change ("1989 Ownership Change") pursuant to Section 382 of the Code, the Section 382 limitation imposed in connection with the Recapitalization would apply to all net operating losses applicable to the period before the Recapitalization.
(7) LONG TERM INCENTIVE PLANS
On September 14, 1992, the Company's Board of Directors adopted the Marine Drilling 1992 Long Term Incentive Plan ("1992 Plan"), which was subsequently approved by the shareholders on October 29, 1992. Pursuant to the terms of the 1992 Plan, an aggregate of 10,000,000 shares (subject to the restrictions described herein) of Common Stock are available for distribution pursuant to stock options, SARs and restricted stock. The number of shares of Common Stock available for distribution as described above is further limited in that no stock options, SARs or restricted stock may be issued if, immediately after such issuance, the number of shares subject to outstanding stock options, SARs and restricted stock awards would exceed 5% of the Common Stock then outstanding. The shares of Common Stock subject to any stock option or SAR that terminates without a payment being made in the form of Common Stock would again become available for distribution pursuant to the 1992 Plan. During 1994 and 1993, respectively, the Company issued 83,000 and 385,000 shares of restricted Common Stock. Compensation expense related to the issuance of restricted Common Stock for the years ended December 31, 1994 and 1993 was $318 and $233, respectively. During 1994 and 1993, respectively, 31,250 and 30,000 shares of restricted Common Stock were forfeited.
Holders of SARs and options granted under the plans existing prior to the adoption of the 1992 Plan surrendered such SARs and options in exchange for options under the 1992 Plan and those prior plans have been terminated.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
During the fourth quarter 1992, 1,440 SARs and 21,640 shares subject to options outstanding under prior plans were exchanged for 23,080 shares subject to option at $1.25 per share under the 1992 Plan. Additionally, options for 1,590,000 shares exercisable at $1.25 were granted on November 3, 1992, options for 190,000 shares exercisable at $6.00 were granted on June 29, 1993 and options for 75,000 shares exercisable at $4.25 were granted on October 12, 1994. All such options expire November 2002, June 2003 and October 2004, respectively, unless earlier exercised. During 1993, 261,030 shares were exercised at $1.25 per share and options for 1,400 shares were forfeited. During 1994, 10,000 shares were exercised at $1.25 per share and options for 30,000 shares were forfeited.
The following table sets forth the shares subject to options outstanding under the 1992 Plan at December 31, 1994:
Based upon Common Stock outstanding as of December 31, 1994 and 1993 and shares reserved for issuance as set forth above, the number of shares then available for future stock options, SARs and restricted stock grants was 432,721 and 423,028 shares, respectively.
(8) RELATED PARTY TRANSACTIONS
The Company has performed services directly for Newfield Exploration Company ("Newfield") and indirectly for Newfield's customers. Amounts received directly from Newfield were $515 during 1992. Amounts received indirectly from Newfield's customers were approximately $526 and $774 during 1993 and 1992, respectively. One of the Company's directors is also a director of Newfield.
The Company has performed services for Houston Exploration Company, Inc. ("Houston"), the operator of certain oil and gas properties with respect to which Smith Offshore Exploration Company ("Smith") participates as a working interest owner. During 1994, 1993 and 1992, the Company recorded revenues of $1,581, $5,658 and $1,356, respectively, from Houston. Aeneas, a principal shareholder of the Company, is a principal shareholder and creditor of Smith.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In connection with the Recapitalization, the Company entered into a loan agreement ("Bridge Loan") with three of its significant shareholders. The Bridge Loan provided for the Company to borrow up to $4,000 at 10%. On October 29, 1992, concurrently with the Recapitalization, the Company issued 3,270,054 shares of Common Stock in full satisfaction of the loan balance of $4,000 and accrued interest thereon.
(9) GEOGRAPHIC AREA ANALYSIS AND MAJOR CUSTOMERS
The following table summarizes geographic area operating revenues and operating income for the years ended December 31, 1994 and 1993, and identifiable assets by geographic area at year-end 1994 and 1993:
There were no significant international operations during 1992.
The Company conducts business in one industry segment, oil and gas well contract drilling. The Company negotiates drilling contracts with a number of customers for varying terms, and management believes it is not dependent upon any single customer. For the years 1994, 1993 and 1992, sales to customers that represented 10% or more of consolidated drilling revenues were as follows:
* Less than 10%
As is typical in the industry, the Company does business with a relatively small number of customers at any given time. The loss of any one of such customers could, at least on a short-term basis, have a material adverse effect on the Company's profitability. Management believes, however, that at current levels of drilling activity, the Company would have alternative customers for its services if it lost any single customer and that the loss of any one customer would not have a material adverse effect on the Company on a long-term basis.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(10) COMMITMENTS
Operating Leases
Aggregate future minimum rental payments relating to operating leases are as follows:
Employee 401(k) Profit Sharing Plan
The Company has a 401(k) Profit Sharing Plan (the "Plan") covering substantially all of its employees who have been employed at least three months. The Company matches employees' contributions to the Plan on a dollar-for- dollar basis, in the form of Company common stock, up to 5% of their eligible compensation. During 1994 and 1993, the Company made matching contributions with the Company's common stock totaling $744 and $354, respectively. During 1992, the Company made no matching contributions.
(11) UNAUDITED QUARTERLY FINANCIAL DATA
A summary of unaudited quarterly consolidated financial information for 1994 and 1993 is as follows:
(1) Quarterly net income per common share may not total to annual results due to rounding. (2) "Average day rate" is determined by dividing the total gross revenue earned by the Company's rigs during a given period by the total number of days that the Company's rigs were under contract during that period.
MARINE DRILLING COMPANIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In 1994, the average day rates earned by the Company's rigs generally declined throughout the year, however, the adverse effects of these declines were partially offset by sequentially higher rig utilization rates through those quarters. The decline in day rates during 1994 was due primarily to (i) increased competition in the U.S. Gulf of Mexico arising from an increased supply of jack-up rigs in that market and (ii) reduced activity levels in Mexico's Bay of Campeche.
Quarterly results during 1993 were virtually the reverse of 1994's due to general day rate increases occurring throughout the year experienced concurrently with consistently high levels of rig utilization. These attributes were the results of (i) a better balance between jack-up rig supply and demand in the U.S. Gulf of Mexico and (ii) high activity levels in the Bay of Campeche.
(12) SUBSEQUENT EVENTS (UNAUDITED)
On November 2, 1994, the Company and Falcon Drilling Company, Inc. ("Falcon") signed a letter of intent to merge. On February 15, 1995, Falcon and the Company agreed to terminate the letter of intent and related discussions because then current market conditions led both parties to conclude that a definitive agreement could not be reached at that time.
On February 28, 1995, the Company repaid $5,000 of the revolving credit facility associated with the Loan described in Note 5 hereto. The Company anticipates that amount will be re-borrowed in addition to other borrowings in 1995 to fund capital expenditures.
Weakness in natural gas prices contributed to a substantial downturn in U.S. Gulf of Mexico drilling activity in early 1995. As a result, the Company's operations and cash flow have been adversely affected. In response to these conditions, the Company has elected to temporarily deactivate some of its rigs and may deactivate additional rigs until market conditions improve.
On March 7, 1995, the Company announced that its Board of Directors had authorized the repurchase of up to 4,000,000 shares of the Company's Common Stock. The purchases may be effected, from time to time, in accordance with applicable securities laws, through solicited or unsolicited transactions in the market or in privately negotiated transactions. No limit was placed on the duration of the repurchase program. Subject to applicable securities laws, such repurchases shall be at such times and in such amounts as the Company deems appropriate. The Company will fund such repurchases from working capital.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
The information called for by Part III, Items 10 through 13, of Form 10-K is incorporated by reference from the Registrant's Proxy Statements relating to its annual meeting of Shareholders to be held May 2, 1995, which will be filed by the Registrant with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year. Also reference is made to the information contained under the captioned "Executive Officers of Registrant" contained in Part I hereof.
PART IV
ITEM 14.

ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following documents are included in Part II, Item 8:
(1) Consolidated Financial Statements
All other schedules are omitted as the information is not required or is not applicable.
(3) Exhibits:
Exhibit Number
3.1 Restated Articles of Incorporation of Marine Drilling Companies, Inc. (Incorporated by reference to Exhibit 28.17 to the Current Report on Form 8-K of the Registrant dated October 30, 1992.)
3.2 Amended and Restated Bylaws of Marine Drilling Companies, Inc. (Incorporated by reference to Exhibit 28.18 to the Current Report on Form 8-K of the Registrant dated October 30, 1992.)
++10.18 The Marine Drilling 1992 Long-Term Incentive Plan. (Incorporated by reference to Exhibit 10.26 of the Company's Registration Statement No. 33-52470 on Form S-1).
10.20 Registration Rights Agreement, dated October 29, 1992, among Marine Drilling Companies, Inc., The Chase Manhattan Bank (National Association), Corpus Christi National Bank, Bank One, Texas, N.A., Energy Management Corporation, Randall D. Smith, Trustee, Kathryn Sladek Smith Trust Article Third B, II of Last Will and Testament of Kathryn Sladek Smith, Warburg, Pincus Capital Company, L.P., Aeneas Venture Corporation, Capricorn Investors, L.P. and William O. Keyes. (Incorporated by reference to Exhibit 28.19 to the Current Report on Form 8-K of the Registrant dated October 30, 1992.)
10.21 Shareholders' Agreement, dated October 29, 1992, among Marine Drilling Companies, Inc., The Chase Manhattan Bank (National Association), Warburg, Pincus Capital Company, L.P., Aeneas Venture Corporation, Capricorn Investors, L.P. and William O. Keyes. (Incorporated by reference to Exhibit 28.20 to the Current Report on Form 8-K of the Registrant dated October 30, 1992.)
10.22 Termination and Amendment Agreement (respecting the Shareholders' Agreement dated October 29, 1992) dated as of June 18, 1993 by and among Marine Drilling Companies, Inc., The Chase Manhattan Bank (National Association), Warburg, Pincus Capital Company, L.P., Aeneas Venture Corporation, Capricorn Investors, L.P. and William O. Keyes. (Incorporated by reference to Exhibit 10.22 to the Annual Report on Form 10-K of the Registrant for the year ended December 31, 1993.)
* 10.23 Loan Agreement and related documents among The CIT Group/Equipment Financing, Inc., as Lender, Marine Drilling Companies, Inc., as Guarantor, and Keyes Holding Corporation, as Borrower, dated as of December 1, 1994.
* 21.1 Subsidiaries of the Registrant.
* 23.1 Consent of Independent Certified Public Accountants.
* 24.1 Powers of attorney.
* 27.1 Financial Data Schedule
_________________________
++ Management contract or compensation plan or arrangement required to be filed as an exhibit to this report.
* Filed herewith.
(b) Reports on Form 8-K:
Three reports on Form 8-K were filed during the fourth quarter of 1994 --
(1) Report of the Company dated November 4, 1994 disclosing that it entered into a letter of intent with Falcon Drilling Company, Inc. to merge the two companies.
(2) Report of the Company dated November 23, 1994 disclosing its consummation of the acquisition of the MARINE 3 jack-up drilling rig.
(3) Report of the Company dated December 6, 1994 disclosing its acquisition of the MARINE 201 (formerly the Nordic Explorer) jack-up drilling rig and the closing of a $35 million credit facility with The CIT Group/Capital Equipment Financing, Inc.
SCHEDULE I
MARINE DRILLING COMPANIES, INC. CONDENSED BALANCE SHEETS (DOLLARS IN THOUSANDS)
See accompanying notes and the notes to the Condensed Financial Statements
SCHEDULE I (CONTINUED)
MARINE DRILLING COMPANIES, INC. CONDENSED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS)
See accompanying notes and the notes to the Condensed Financial Statements
SCHEDULE I (CONTINUED)
MARINE DRILLING COMPANIES, INC. CONDENSED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
[Continued]
See accompanying notes and the notes to the Condensed Financial Statements
SCHEDULE I (CONTINUED)
MARINE DRILLING COMPANIES, INC. CONDENSED STATEMENTS OF CASH FLOWS -- (CONTINUED) (DOLLARS IN THOUSANDS)
See accompanying notes and the notes to the Condensed Financial Statements
SCHEDULE I (CONTINUED)
MARINE DRILLING COMPANIES, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1994, 1993 AND 1992
(1) SOURCES OF FUNDING AND SUBSIDIARIES' FUNDING REQUIREMENTS
The Company's primary source of funding consists of dividends, distributions and repayments of intercompany advances and loans by its subsidiaries.
To the extent that the Company's subsidiaries have funding requirements in excess of amounts available from operations (if any), those subsidiaries' primary source of funding is from the Company.
(2) INVESTMENT IN AND AMOUNTS DUE FROM SUBSIDIARIES
Due to the restrictions on intercompany payments, amounts due from certain subsidiaries have been classified as non-current assets.
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) 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, IN THE CITY OF SUGAR LAND, STATE OF TEXAS, ON THIS 7TH DAY OF MARCH 1995.
MARINE DRILLING COMPANIES, INC.
By /s/ William O. Keyes ----------------------------------- William O. Keyes President
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED:
INDEX TO EXHIBITS


ITEM 1. BUSINESS.
General IDS/Shurgard Income Growth Partners L.P. II was organized under the laws of the State of Washington on November 15, 1988. The General Partner is Shurgard Associates L.P. II. The Partnership will terminate December 31, 2030, unless terminated at an earlier date.
The business of the Partnership is to acquire, develop and operate storage centers. The principal investment objectives of the Partnership are to provide the Limited Partners with regular quarterly cash distributions which, for Taxable Limited Partners, are expected to be partially tax-sheltered; to obtain long-term appreciation in the value of its properties; and to preserve and protect the Limited Partners' capital. The Partnership began operations during 1989, at which time it obtained approximately $10.3 million in short-term financing for the purchase of two existing storage facilities. The offering was completed in April 1990 with total proceeds raised through the sale of limited partnership interest of approximately $28.8 million. This enabled the Partnership to retire the short-term loans and purchase an additional five existing storage centers and one partially completed facility. For more information regarding the properties owned by the Partnership at December 31, 1994, see Item 2

ITEM 2. PROPERTIES.
The following table lists each of the Partnership's storage centers at December 31, 1994, the metropolitan area they serve, the respective rentable space, the acquisition or completion date, and the square foot occupancy at December 31, 1994, 1993 and 1992.
Shurgard of Kennydale was purchased from an affiliated partnership after approval by a majority vote of limited partners. The Houston, Texas center was purchased from Shurgard Incorporated at its net cost. The remaining six centers were purchased from unaffiliated sellers.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS.
None.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
(a) Market information. There is no established public market for the Partnership's units of limited partnership interest. Transfers of limited partner interests are restricted in certain circumstances. Transfers which would result in the termination of the Partnership under Section 708 of the Internal Revenue Code, transfers of fractional units, and transfers which result in a limited partner owning less than the minimum number of units are restricted. There is a fee charged for transfers.
(b) Holders. As of February 6, 1994, there was one general partner and approximately 4,200 limited partners in the Partnership.
(c) Distributions. During the fiscal years ended December 31, 1993 and 1994, the Partnership distributed $15.62 and $15.78 respectively, per $250 unit of limited partnership interest. In February 1995, the Partnership distributed $4.06 per $250 unit of limited partnership interest. As of December 31, 1994, total distributions of $9,036,743 are greater than total earnings on a basis consistent with generally accepted accounting principles by $3,145,188. Therefore, the partners' original investment has been reduced by that amount for financial reporting purposes.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA.
The information called for by this item is incorporated by reference of the Annual Report to Security Holders for the fiscal year ended December 31, 1994, a copy of which is filed as Exhibit 13.
ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND THE RESULTS OF OPERATIONS.
The information called for by this item is incorporated by reference of the Annual Report to Security Holders for the fiscal year ended December 31, 1994, a copy of which is filed as Exhibit 13.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information called for by this item is incorporated by reference of the Annual Report to Security Holders for the fiscal year ended December 31, 1994, a copy of which is filed as Exhibit 13.
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The Partnership's General Partner is Shurgard Associates L.P. II, a Washington limited partnership. Shurgard Associates L.P. II is managed by the directors and executive officers of Shurgard General Partner, Inc., the corporate General Partner, and by the Individual General Partners. Shurgard Incorporated and IDS Partnership Services Corporation (IPSC), a Minnesota corporation, are limited partners of Shurgard Associates L.P. II, and as such, do not control the day-to-day affairs of the General Partner or, through the General Partner, the Partnership. Management of the operations of Partnership projects is performed by Shurgard Incorporated pursuant to the Management Services Agreement.
The directors of Shurgard General Partner, Inc. have been elected to serve until their successors are duly elected and qualified. As the sole shareholder of Shurgard General Partner, Inc., Charles K. Barbo is in a position to control the election of directors. Mr. Barbo is a party to a business agreement whereby he shall use his best efforts to cause Donald B. Daniels to be elected a vice president and director of Shurgard General Partner, Inc., so long as Mr. Daniels is willing to serve in such positions.
The directors and officers of Shurgard General Partner, Inc., are required to devote only so much of their time to the Partnership's affairs as is necessary or required for the effective conduct and operation of the Partnership's business. The Individual General Partners devote their individual time to the Partnership to the extent they deem advisable in view of the participation of Shurgard Incorporated in Partnership affairs and such other factors as they consider relevant.
The Individual General Partners of Shurgard Associates L.P. II and the executive officers, directors and certain key personnel of Shurgard General Partner, Inc., and Shurgard Incorporated are as follows:
Name Age Company Office and Date of Election ------------------ --- ---------------------------- --------------------------- Charles K. Barbo 53 Shurgard Associates L.P. II Individual General Partner (1988) Shurgard Incorporated President (1992), Chairman of the Board (1979) Shurgard General Partner, President (1992), Chairman Inc. of the Board (1983)
Arthur W. Buerk 58 Shurgard Associates L.P. II Individual General Partner (1988) Shurgard Incorporated Director (1982) Shurgard General Partner, Director (1979) Inc.
Donald B. Daniels 56 Shurgard Incorporated Vice President (1983), Director (1972) Shurgard General Partner, Vice President (1983), Inc. Director (1979)
Kristin H. Stred 36 Shurgard Incorporated Secretary (1992) Shurgard General Partner, Secretary (1992) Inc.
Michael Rowe 38 Shurgard Incorporated Executive Vice President (1993) Harrell Beck 38 Shurgard Incorporated Treasurer (1992) Shurgard General Partner, Treasurer (1992) Inc.
David Grant 41 Shurgard Incorporated Executive Vice President (1993)
On March 24, 1995, Shurgard Incorporated was merged into Shurgard Storage Centers, Inc. ("SSCI"). Pursuant to this merger, Shurgard Storage Centers, Inc. succeeds to rights and responsibilities of Shurgard Incorporated and will perform all the duties previously performed by Shurgard Incorporated, including supervision of the operation of the Partnership projects. The directors, executive officers and key personnel of Shurgard Storage Centers, Inc. are as follows:
Charles K. Barbo has been involved as a principal in the real estate investment industry since 1969. Mr. Barbo is one of the co-founders of Shurgard Incorporated, which was organized in 1972 to provide property management services for self-service storage facilities and other real estate and commercial ventures. Mr. Barbo was also a co-founder of Shurgard General Partner, Inc. Upon Mr. Buerk's resignation on January 1, 1992, Mr. Barbo assumed the responsibilities of President of Shurgard Incorporated until March 24, 1995 and Shurgard General Partner, Inc. Mr. Barbo is also a general partner in a number of other public real estate partnerships. On March 24, 1995, Mr. Barbo was named the Chairman of the Board, President and Chief Executive Officer of Shurgard Storage Centers, Inc.
Arthur W. Buerk joined Shurgard Incorporated in 1977. During the ensuing years, Mr. Buerk shared with Messrs. Barbo and Daniels (see below) the various executive management functions within Shurgard Incorporated. Mr. Buerk served as President of Shurgard Incorporated from 1979 to 1991 and Shurgard General Partner, Inc. from 1983 to 1991. Effective January 1, 1992, Mr. Buerk resigned as President of both Shurgard Incorporated and Shurgard General Partner, Inc. to pursue other avenues of interest. He remains a director of Shurgard General Partner Inc. as well as a general partner of Shurgard Associates L.P. II and until March 24, 1995, remained a director of Shurgard Incorporated. Mr. Buerk is also a general partner in a number of other public real estate partnerships. Mr. Buerk holds no office in Shurgard Storage Centers, Inc.
Donald B. Daniels has been involved in the real estate investment industry since 1971 and in the self-service storage industry since 1974. Mr. Daniels is one of the co-founders of Shurgard Incorporated. He is a director of Shurgard General Partner, Inc. and was a director of Shurgard Incorporated until March 24,1995. Mr. Daniels is also a general partner in a number of other real estate partnerships. Mr. Daniels holds no office in Shurgard Storage Centers, Inc.
Kristin H. Stred joined Shurgard Incorporated in 1992. She served as General Counsel and Secretary of Shurgard Incorporated until March 24, 1995 and currently serves as Secretary of Shurgard General Partner, Inc. Ms. Stred served as a corporate attorney in the broadcasting and aerospace industries from 1987 to 1992. On March 24, 1995, Ms. Stred was named Senior Vice President of Shurgard Storage Centers, Inc. She also serves as Secretary and general counsel of Shurgard Storage Centers, Inc.
Michael Rowe came to Shurgard Incorporated as Controller in 1982. In 1983, he became a Vice President and, in 1987, was named Director of Operations of Shurgard Incorporated. Mr. Rowe served as Treasurer of both Shurgard Incorporated and Shurgard General Partner, Inc. from 1983 to 1992. He served as Executive Vice President of Shurgard Incorporated from 1993 until March 24, 1995. Mr. Rowe currently serves as Executive Vice President of Shurgard Storage Centers, Inc.
Harrell Beck joined Shurgard Incorporated in April 1986 as the Eastern Regional Operations Manager and, in 1990, he became the Chief Financial Officer. Mr. Beck served as Treasurer of Shurgard Incorporated from 1992 until March 24, 1995. He currently serves as Director, Treasurer and CFO of Shurgard Storage Centers, Inc. as well as Treasurer of Shurgard General Partner, Inc. On March 24, 1995, Mr. Beck was named Senior Vice President of Shurgard Storage Centers, Inc.
David K. Grant joined Shurgard Incorporated in November 1985 as Director of Real Estate Investment. Mr. Grant was elected Vice President of Shurgard Incorporated in 1992 and Executive Vice President in 1993. On March 24, 1995, Mr. Grant was named Executive Vice President of Shurgard Storage Centers, Inc.
Dan Kourkoumelis has served as a director of Shurgard Storage Centers, Inc. since March 1994. He is the President, Chief Operating Officer and a director of Quality Food Centers, Inc. ("QFC"), a publicly held corporation that operates the largest independent supermarket chain in the Seattle area. Mr. Kourkoumelis joined QFC in 1967 and has held a variety of positions since then. He served as Executive Vice President from 1983 to 1987, when he also became Chief Operating Officer, and became President in 1989 and a director in 1991.
Donald W. Lusk has served as a director of Shurgard Storage Centers, Inc. since March 1994. He is the President of Lusk Consulting Group, which is engaged in general management consulting, as well as the formation and delivery of management development programs in Western Canada. From 1974 to 1991, Mr. Lusk was Regional Managing Partner of Management Action Programs in the Pacific Northwest.
Wendell J. Smith has served as a director of Shurgard Storage Centers, Inc. since March 1994. He retired in 1991 from the State of California Public Employees Retirement System ("Calpers") after 27 years of employment, the last 21 in charge of all real estate equities and mortgage acquisitions for Calpers. During those 21 years, Calpers invested over $8 billion in real estate and mortgages. In 1991, Mr. Smith established W.J.S. & Associates, which provides advisory and consulting services for pension funds and pension fund advisors.
Pursuant to Articles 16 and 17 of the Agreement of Limited Partnership, a copy of which is filed as an exhibit to the Partnership's Registration Statement, each of the general partners continues to serve until (i) death, insanity, insolvency, bankruptcy or dissolution, (ii) withdrawal with the consent of the other general partners (if any) and a majority vote of the limited partners, or (iii) removal by a majority vote of the limited partners.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION.
Number of Capacities Persons in in which Cash Group Served Compensation ----------------------------------- --------------- 1 General Partner 95,600*
*The General Partner has a 5% interest in cash distributions made by the Partnership, which is disproportionate to its share of the capital of the Partnership, which is .0035%. This amount represents the portion of cash distributions made to the General Partner during the fiscal year ended December 31, 1994, which is in excess of what a proportionate share of distributions would have been.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) Security ownership of certain beneficial owners as of February 6, 1995: None owning more than 5% of the Partnership's voting securities.
(b) Security ownership of management as of February 6, 1995: Management's security ownership in Shurgard Associates L.P. II as of February 6, 1995 was as follows:
Title of Name of Percent Class Beneficial Owner of Class -------- ------------------------------- --------- General Shurgard General Partner, Inc.1,2 .2% Partners' Charles K. Barbo2 9.9% Interest Arthur W. Buerk2 9.9% Shurgard Incorporated3,4 40.0% IDS Partnership Services Corporation3 40.0% ---- 100.0% ====
1 Charles K. Barbo owns 100% of the stock of Shurgard General Partner, Inc. 2 Owner is a General Partner of Shurgard Associates L.P. II. 3 Owner is a Limited Partner of Shurgard Associates L.P. II. 4 On March 24, 1995, these interests were transferred to Shurgard Storage Centers, Inc. pursuant to the merger. Although Shurgard Storage Centers, Inc. acquired through the merger Shurgard Incorporated's interest in the General Partner, substantially all of the appreciation in the value of that interest during the next five years will inure to the benefit of the shareholders of Shurgard Incorporated in the form of additional shares of Shurgard Storage Centers, Inc. As a consequence, the future benefits to be derived from the interest in the General Partner (except current operating cash flow and appreciation after five years), if any, will be received by the shareholders of Shurgard Incorporated (including members of management of Shurgard Storage Centers, Inc.) and not by Shurgard Storage Centers, Inc. or its shareholders."
(c) Changes in control: On March 24, 1995, Shurgard Incorporated was acquired by Shurgard Storage Centers, Inc. Pursuant to this merger, Shurgard Storage Centers, Inc. will perform all the duties previously performed by Shurgard Incorporated, including supervision of the operation of the Partnership projects. For the directors, executive officers, key personnel of Shurgard Storage Centers, Inc. and a description of the circumstances under which the General Partner may be removed, see Item 10 of this form 10K.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The Partnership agreement provides a fee payable to Shurgard Incorporated for property management services equal to 6% of gross revenues from self-service storage operations for day-to-day professional property management services. The monthly fee for management services will be reduced to 3% if leasing services are performed by a party other than Shurgard Incorporated. Payments to Shurgard Incorporated for such management totaled $242,259 for the year ended December 31, 1994. Subsequent to March 24, 1995, the property management services will be performed by Shurgard Storage Centers, Inc.
Note C at page 9 of the Annual Report to Security Holders for the year ended December 31, 1994, a copy of which is included as Exhibit 13, is incorporated by reference. In addition, Shurgard Incorporated will receive fees from the Partnership as specified in the Agreement of Limited Partnership, reference to which is made as Exhibit 3(a), and in the Management Services Agreement, reference to which is made as Exhibit 10(a), both of which documents are incorporated by reference. Shurgard Storage Centers, Inc. will succeed Shurgard Incorporated with respect to these agreements. On March 24, 1995 pursuant to the merger, the shareholders of Shurgard Incorporated received shares of Shurgard Storage Centers, Inc. The following persons owned approximately the designated percentages of the named corporation's outstanding common stock.
Ownership Ownership of Shurgard of Person Relationship to Partnership Inc. SSCI (1) ----- -------------------------------- ---------- ---------
Charles K. Barbo Individual General Partner of Shurgard Associates L.P. President and Chairman of the Board of Shurgard General Partner, Inc. 48% 4%
Arthur W. Buerk Individual General Partner of Shurgard Associates L.P. 25% * Director of Shurgard General Partner, Inc.
Donald B. Daniels Director and Vice President of Shurgard General Partner, Inc. 13% *
As shareholders of the named corporation these individuals may benefit indirectly from the transactions disclosed in this item.
(1) Pursuant to the terms of the merger, Shurgard Incorporated shareholders will be entitled to receive additional Shurgard Storage Centers, Inc. shares based on (i) the extent to which, during the five years following the closing of the merger, Shurgard Storage Centers, Inc. realized value as a result of certain transactions relating to, among others, Shurgard Storage Centers, Inc.'s interest in the General Partner and (ii) the value, at the end of five years or in the event of a change of control, of any remaining interests in the General Partner as determined by independent appraisal. The ownership percentages in SSCI above do not reflect theses additional shares.
* Mr. Buerk and Mr. Daniels each own less than 1% of SSCI.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8- -K.
(a) 1. Financial statements:
The following financial statements of IDS/Shurgard Income Growth Partners L.P. II are incorporated by reference in Part II and are filed as Exhibit 13:
Balance sheets - December 31, 1994 and 1993 Statements of earnings - Three years ended December 31, 1994 Statements of partners' equity (deficit) - Three years ended December 31, 1994 Statements of cash flows - Three years ended December 31, 1994 Notes to combined financial statements - Three years ended December 31, 1994 Independent auditors' report
2. All schedules are omitted because either they are not applicable or the required information is shown in the financial statements or notes thereto.
3. Exhibits:
All exhibits to this report are listed in the Exhibit Index.
(b) Reports on Form 8-K:
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Date: March 29, 1995 IDS/SHURGARD INCOME GROWTH PARTNERS L.P. II
By: Shurgard Associates L.P. II, General Partner
By: Shurgard General Partner, Inc. General Partner
By: HARRELL BECK Harrell Beck, Treasurer
By: CHARLES K. BARBO Charles K. Barbo, General Partner
By: ARTHUR W. BUERK Arthur W. Buerk, General Partner
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:
Signature Title Date ---------------- ---------------------------------- ---------------
CHARLES K. BARBO President, Chairman of the Board and March 29, 1995 Charles K. Barbo Director of Shurgard General Partner, Inc. (principal executive officer)
ARTHUR W. BUERK Director of Shurgard General Partner, Inc. March 29, 1995 Arthur W. Buerk (principal executive officer)
HARRELL BECK Treasurer of Shurgard General Partner, Inc. March 29, 1995 Harrell Beck (principal financial officer and principal accounting officer)
Exhibit Index
Exhibit Reference or Sequential Page Number ----------------------------------- ------------------------------------ 3. Articles of incorporation and by-laws Filed as Exhibit 3 to Form S-11 for (a) Agreement of Limited Partnership Registration No. 33-25729 4. Instruments defining the rights of See Exhibit 3(a), above security holders, including indentures 10. Material contracts: Filed as Exhibit 10(a) to Form S-11 (a) Management Services Agreement for Registration No. 33-25729 13. Annual report to security holders Filed as Exhibit 13 to Form 10 K for Registration No. 33-25729 21. Subsidiaries of the registrant See Item 1 of this Form 10-K
27. Financial Data Schedule Filed as Exhibit 27 to Form 10 K for Registration No. 33-25729