ITEM 1. BUSINESS
SEMCO ENERGY, INC.
SEMCO Energy, Inc. is a diversified energy services and infrastructure holding company headquartered in southeastern Michigan. The Company was incorporated in Michigan in 1977. SEMCO Energy, Inc. and its subsidiaries (the "Company") operate five energy-related business segments. The business segments are gas distribution, engineering services, construction services, energy marketing and propane, pipelines and storage. The Company had approximately 860 employees at December 31, 1998.
ITEM 1. BUSINESS (CONT.)
GAS DISTRIBUTION
The Company's gas distribution business segment ("Gas Company") serves nearly 250,000 customers in twenty-four of the counties in the state of Michigan. It distributes and transports natural gas to residential, commercial and industrial customers. The Company's gas distribution business is operated through its SEMCO Energy Gas Company subsidiary and is its largest business segment. Set forth in the table below is gas sales and transportation information for the past three years:
Refer to Note 12 of the Notes to the Consolidated Financial Statements for the Gas Company's operating revenues, operating income, assets and other financial information for the past three years.
Gas Sales. The Gas Company sells and delivers natural gas to residential, commercial and industrial customers. Revenues are generated primarily through sales to residential and commercial customers. These customers use natural gas mainly for space heating purposes. Consequently, weather has a significant impact on sales. Given the impact of weather on this business, most gas sales revenue is earned in the first and fourth quarters of the calendar year. Operating revenues from gas sales accounted for 26%, 28% and 40% of consolidated operating revenues in 1998, 1997 and 1996, respectively. If operating revenues from the Company's marketing business, which the Company entered into an agreement to sell in March 1999, are excluded, gas sales by the Gas Company would have accounted for 68%, 88% and 92% of consolidated operating revenues for those three years. Competition in the gas sales market arises from the availability of alternate energy sources such as electricity, propane and oil. However, this competition is inhibited because of the time, inconvenience and investment for residential and commercial customers to convert to an alternate energy source when the price of natural gas fluctuates.
ITEM 1. BUSINESS (CONT.)
GAS DISTRIBUTION (CONT.)
The Gas Company continues to increase its customer base. Since 1988, it has added 59,225 customers, or approximately 6,000 customers per year. These additions have been primarily residential and are a result of expanded service territories, conversion of existing homes and new home construction. On April 1, 1998, an aggregation tariff became effective and provides commercial and industrial customers the opportunity to aggregate multiple service locations and purchase their gas from a third-party supplier, while allowing the Gas Company to continue charging the existing distribution charges and customer fees. Refer to Management's Discussion and Analysis for further information regarding the impact of the aggregation tariff on gas sales and transportation revenue.
Transportation. The Gas Company provides transportation services to its large-volume commercial and industrial customers. This service offers those customers the option of purchasing natural gas directly from producers or marketing companies while utilizing the Gas Company's distribution network to transport the gas to their facilities. The market price of alternate energy sources such as coal, electricity, oil and steam is the primary competitive factor affecting the demand for transportation. Many large industrial customers have some limited ability to convert to another form of energy when the price of natural gas increases significantly. In addition, downward pressure on transportation rates has resulted from the potential for industrial and power plants located on various parts of the Gas Company's distribution system to connect directly to interstate natural gas pipelines and bypass the Gas Company. Refer to Management's Discussion and Analysis for additional information regarding bypass potential. Partially offsetting the impact of price sensitivity has been the use of natural gas as an industrial fuel because of clean air legislation and the resultant pressures on industry and electric utilities to reduce emissions from their plants.
Gas Supply. The Gas Company is served by four major interstate pipelines: Panhandle Eastern Pipe Line Company, Northern Natural Gas Company, Great Lakes Gas Transmission Company and ANR Pipeline Company. Natural gas purchases are transported to the Gas Company's systems under various firm and interruptible transportation arrangements with interstate and intrastate transmission companies. The Gas Company utilizes on-system and leased storage capacity of 35% to 40% of average annual gas sales volumes to reduce its reliance on the interstate pipelines for peak day needs and allow for the purchase of natural gas at lower prices. The Gas Company owns underground storage facilities with a working capacity of 5.0 billion cubic feet ("Bcf"). In addition, it leases 6.5 Bcf of storage from Eaton Rapids Gas Storage System and 4.5 Bcf from non-affiliates. SEMCO Gas Storage Company (an affiliated company) is a 50% owner of Eaton Rapids Gas Storage System.
ITEM 1. BUSINESS (CONT.)
GAS DISTRIBUTION (CONT.)
The Company has entered into an agreement with TransCanada Gas Services, Inc., under which the latter will provide the Gas Company's natural gas requirements and manage the Gas Company's natural gas supply and the supply aspects of transportation and storage operations for the three year period beginning April 1, 1999. Refer to Note 2 of the Notes to the Consolidated Financial Statements for additional information about the agreement.
Rates and Regulation. The Gas Company is subject to the jurisdiction of the Michigan Public Service Commission ("MPSC") as to various phases of its operations including rates, accounting and service standards. However, rates charged to customers in the Battle Creek division are subject to the jurisdiction of the City Commissioners of Battle Creek, Michigan. Management periodically reviews the adequacy of the Gas Company's rates and files requests for rate increases whenever it is deemed necessary and appropriate. However, a recent rate case includes provisions limiting the Gas Company's ability to request a rate increase during the next three years. Refer to Note 2 of the Notes to the Consolidated Financial Statements for further information on regulatory matters including the authorization by the MPSC to suspend the Gas Company's gas cost recovery ("GCR") clause and freeze for three years in its base rates a gas charge of $3.24 per Mcf.
Environmental Matters. The Gas Company currently owns seven sites which formerly housed manufactured gas plants. In the earlier part of this century, gas was manufactured from processes using coal, coke or oil. By-products of this process have left some contamination at these sites. The Company has submitted a plan to the State of Michigan for the proposed clean up at one of these sites. Refer to Note 14 of the Notes to the Consolidated Financial Statements for further discussion.
ENGINEERING SERVICES
The Company's engineering services business segment ("Engineering Services") is comprised of two companies, Maverick Pipeline Services, Inc. ("Maverick") and Oilfield Materials Consultants, Inc. ("OMC"). Maverick was acquired in December 1997 and was accounted for as a purchase. OMC was acquired in November 1998 and was accounted for as a pooling of interests (see Note 3 of the Notes to the Consolidated Financial Statements for information regarding acquisitions accounted for as a purchase or as a pooling of interests). Engineering Services has offices in New Jersey, Michigan, Louisiana and Texas and provides a variety of energy related engineering services in several states. Refer to Note 12 of the Notes to the Consolidated Financial Statements for Engineering Services' operating revenues, operating income, assets and other financial information for the past three years.
ITEM 1. BUSINESS (CONT.)
ENGINEERING SERVICES (CONT.)
Engineering Services serves the natural gas distribution and transmission, oil products, exploration/production and telecommunication industries. The primary services provided include engineering design, project management, field surveying, inspecting, testing, pipeline-mill quality assurance and full turnkey service. Engineering Services competes with regional, national and international firms as well as in-house engineering and field service departments. Refer to Management's Discussion and Analysis for further discussion concerning competitio-n in the engineering services industry. With the recent downturn in oil prices, there has been a reduction in oil and gas production and related activities, as a result of which OMC has experienced a reduction in the level of available construction inspection and quality assurance projects. Management believes that the level of these activities and available projects will increase as oil prices recover.
CONSTRUCTION SERVICES
The Company's construction services business segment ("Construction Services") has offices in Michigan and Tennessee as of December 31, 1998. Its primary service is underground pipeline installation and replacement for the natural gas distribution industry. As of December, 31 1998, the construction services segment was comprised of two companies, Sub-Surface Construction Co. ("Sub-Surface") and King Energy & Construction Co. ("King"). Sub-Surface was acquired in August 1997 and King was acquired in May 1998. Both acquisitions were accounted for as purchases. Refer to Note 12 of the Notes to the Consolidated Financial Statements for Constructions Services' operating revenues, operating income, assets and other financial information for the past two years. In January 1999, the Company acquired K&B Construction, Inc. ("K&B"). As of December 31, 1998 K&B employed 117 employees and had 1998 revenues of approximately $9 million. K&B provides underground construction services in Kansas and Missouri. The natural gas construction services industry is comprised of a highly fragmented group of companies focused primarily on regional or local markets. The top six construction companies in the country have less than 6% of the market. Approximately 30% of the market represents work done by utility companies' in-house construction departments with the remainder of the market being served by a large number of small- and medium-size companies. The Company plans to expand Construction Services' market share significantly over the next several years by acquiring small- to medium-size companies that have a strong customer base. Construction Services' business is seasonal in nature. Most of this segment's annual profits are made during the summer and fall months. Construction Services generally incurs losses during the winter months when underground construction is inhibited.
ITEM 1. BUSINESS (CONT.)
PROPANE, PIPELINES AND STORAGE
The Company's pipelines and storage operations consist of several pipelines and a gas storage facility. The Company has partial ownership interests or equity interests in certain of these operations. The pipelines and storage operations are all located in Michigan. Refer to Item 2
ITEM 2. PROPERTIES
SEMCO ENERGY, INC.
The properties of the SEMCO Energy, Inc. consist of the common stock of its first-tier subsidiaries, leasehold improvements and office equipment.
GAS DISTRIBUTION
The Gas Company owns gas supply systems which, on December 31, 1998, included approximately 151 miles of transmission pipelines and 5,170 miles of distribution pipelines. The pipelines are located throughout the southern half of Michigan's lower peninsula (centered around the cities of Port Huron, Albion, Battle Creek and Holland) and also in the central and western areas of Michigan's upper peninsula. The Gas Company's distribution system and service lines are, for the most part, located on or under public streets, alleys, highways and other public places, or on private property not owned by the Gas Company with permission or consent, except to an inconsequential extent, of the individual owners. The distribution systems and service lines located on or under public streets, alleys, highways and other public places were all installed under valid rights and consents granted by appropriate local authorities. The Gas Company owns and operates underground gas storage facilities in eight depleted salt caverns and two depleted gas fields together with measuring, compressor and transmission facilities. The aggregate working capacity of the storage system is approximately 5.0 Bcf. The Gas Company also owns meters and service lines, gas regulating and metering stations, garages, warehouses and other buildings necessary and useful in conducting its business. It leases its computer and transportation equipment.
ITEM 2. PROPERTIES (CONT.)
ENGINEERING SERVICES
Engineering Services' properties include primarily computers, trucks, testing equipment and related devices required to perform engineering and related services. Much of the equipment is portable and is used by the Company's employees at customer worksites throughout several states.
CONSTRUCTION SERVICES
The tangible properties of Construction Services include equipment required for the installation, repair or replacement of underground pipelines or similar items. This includes primarily equipment necessary for excavation such as backhoes, trenchers, directional drills and dumptrucks. This equipment can be driven or carried on trailers from one worksite to another. Substantially all of Construction Services' equipment at December 31, 1998 was located in Michigan and Tennessee.
PROPANE, PIPELINES AND STORAGE
The principal properties of this business segment include interests and operations in propane distribution, natural gas transmission and gathering and an underground gas storage system.
The Company owns a 50% equity interest in the Eaton Rapids Gas Storage System. This system, located near Eaton Rapids, Michigan, became operational in March 1990 and consists of approximately 12.8 Bcf of underground storage capacity. Of the total, 6.5 Bcf is leased by the Gas Company. The Company also owns 50% of the Michigan Intrastate Pipeline System and the Michigan Intrastate Lateral System partnerships. The sole purpose of these partnerships is to hold a 10% ownership of the Saginaw Bay Pipeline Project, a 126-mile pipeline from Michigan's Saginaw Bay area to processing plants in Kalkaska, Michigan. The property of the propane distribution operation consists primarily of pressurized propane storage tanks used by customers to store propane purchased from the Company and trucks for transporting propane. The Company also owns large propane storage tanks that allow the Company to store up to 258,000 gallons of propane inventory. The propane distribution property is all located in Michigan's upper peninsula and northeast Wisconsin.
ITEM 2. PROPERTIES (CONT.)
PROPANE, PIPELINES AND STORAGE (CONT.)
The Litchfield Lateral is a 31-mile pipeline located in southwest Michigan. The line, which is leased entirely to ANR Pipeline Company, links the Eaton Rapids Gas Storage System with interstate pipeline supplies. The Litchfield Lateral began operations in February 1993. The Greenwood Pipeline, an 18-mile pipeline, was constructed in 1991, to serve Detroit Edison's Greenwood power plant located in Michigan's thumb area. The Company and Detroit Edison have entered into an agreement whereby Detroit Edison has contracted for the entire capacity of the line which amounts to 240 million cubic feet ("MMcf") per day. The Iosco-Reno System includes the Iosco County Pipeline and Reno Gas Processing Plant, which was placed in service in March 1992. The Iosco-Reno System gathers and processes wet gas in the Au Gres and Santiago fields located in mid-Michigan for delivery to the processing plant and ultimate delivery to the gas markets. The Eaton Rapids Pipeline is a 7.1 mile pipeline constructed in 1990. It provides direct delivery of gas from the Eaton Rapids Gas Storage System to the Gas Company's customers located in Battle Creek and Albion, Michigan.
ENERGY MARKETING
The properties of Energy Services include primarily computers and office furniture and equipment. At December 31, 1998 all such property was located in the state of Michigan.
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 PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET PRICE AND NASDAQ LISTING
NASDAQ Trading Symbol "SMGS" The common stock of the Company is traded on The Nasdaq Stock Market under the symbol "SMGS." The table below shows high and low closing bid prices of the Company's common stock in the over-the-counter market as reported in the Wall Street Journal adjusted to reflect the 5% stock dividends in May 1998 and 1997. These quotations reflect dealer prices, without brokerage commission, and may not necessarily represent actual transactions.
See the cover page for a recent stock price and the number of shares outstanding. See Selected Financial Data for the number of shareholders at year end for the past five years. The Company issued unregistered shares of its common stock in connection with certain acquisition transactions during 1998. See Note 3 of the Notes to the Consolidated Financial Statements.
DIVIDENDS
See Notes 5 and 16 of the Notes to the Consolidated Financial Statements and Selected Financial Data.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
NET INCOME. The Company's net income was $10.0 million (or $0.63 per share) in 1998. The unseasonably warm weather throughout 1998 had a significant impact on earnings. On a weather-normalized basis, net income for 1998 would have been $17.2 million (or $1.08 per share). The following table shows the net income and earnings per share ("EPS") for the past three years, as well as the impact of weather, the divestiture of the NOARK investment, a change in accounting method and an extraordinary charge.
The divestiture of NOARK, the change in accounting method and the extraordinary charge are all discussed in greater detail after the following discussions regarding the Company's business segments.
SUMMARY OF BUSINESS SEGMENTS
The Company has five business segments. They are gas distribution, engineering services, construction services, energy marketing and propane, pipelines and storage. Refer to Notes 1 and 12 of the Notes to the Consolidated Financial Statements for additional information regarding each business segment. The following table shows the operating revenues and operating income of each business segment as well as a reconciliation ("Corporate and other") of the segment information to the applicable line in the consolidated financial statements. Corporate and other includes corporate related expenses not allocated to segments, intercompany eliminations and results of other smaller operations.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
SUMMARY OF BUSINESS SEGMENTS (CONT.)
Each business segment is discussed separately on the following pages. The Company evaluates the performance of its business segments based on the operating income generated. Operating income does not include non-operating items such as income taxes, interest expense, extraordinary charges, changes in accounting method and non-operating income and expense items. A review of the non-operating items follows the business segment discussions.
GAS DISTRIBUTION
WARMER TEMPERATURES IMPACT EARNINGS. The Company's operating income from its gas distribution business segment ("Gas Company") declined in 1998 due primarily to the impact of the unseasonably warm temperatures throughout the year. On a weather-normalized basis, the Gas Company's operating income would have increased by $6.8 million in 1998 when compared to 1997 and by $.8 million in 1997 compared to 1996.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
GAS DISTRIBUTION (CONT.)
GAS SALES MARGIN. In 1998, gas sales margin decreased by $9.9 million (or 15%) compared to 1997. This was due primarily to lower gas sales resulting from the unseasonably warm weather during 1998 and the adoption of a new aggregation tariff, offset partially by the addition of new gas sales customers and a rate increase in October 1997. The weather during 1998 was 20% warmer than normal. $10.8 million of the decrease in operating income is attributable to the warm temperatures. The aggregation tariff, which was effective April 1, 1998, provides all commercial and industrial customers the opportunity to purchase their gas from a third-party supplier, while allowing the Gas Company to continue charging the existing distribution charges and customer fees. The program is referred to as the aggregated transportation service ("ATS") program. Distribution charges and customer fees associated with customers who have switched to third-party gas suppliers are recorded in gas transportation revenue rather than gas sales revenue because the Gas Company is now acting as a transporter for those customers. Therefore, the decrease in gas sales margin due to customers switching to third-party suppliers ($2.5 million) is offset by a corresponding increase in gas transportation revenue. The addition of new customers increased gas sales margin by $1.8 million in 1998. The Gas Company added an average of 7,359 new gas sales customers in 1998. During the same period, an average of 2,900 gas sales customers switched from gas sales service to the Company's new ATS program. The October 1997 rate increase was granted primarily to allow for the recovery of costs related to a change in accounting for retiree medical benefits. The rate increase and aggregation tariff referenced above were approved in the October 1997 Order of the Michigan Public Service Commission ("1997 rate case") (see Note 2 in the Notes to the Consolidated Financial Statements).
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
GAS DISTRIBUTION (CONT.)
In 1997, gas sales margin decreased by $1.0 million (or 2%), when compared to 1996, due primarily to lower gas sales resulting from warmer temperatures and several industrial gas sales customers converting to transportation. Weather was essentially normal in 1997 but was approximately 4% warmer than 1996. The impact of these items was offset partially by the addition of an average of 7,809 (or 3%) new gas sales customers in 1997.
GAS TRANSPORTATION REVENUE. Gas transportation revenue increased by $1.6 million in 1998 when compared to 1997, due primarily to revenues from the new ATS program discussed previously ($2.5 million), offset partially by lower off-peak transportation rates approved in the 1997 rate case. The new off-peak transportation rates are in effect from April through October and are $0.15 per Mcf lower than the Gas Company's regular transportation rates. Gas transportation revenue increased by $.9 million in 1997 when compared to 1996. This increase is primarily attributable to additional transportation customers, most of which were previously gas sales customers.
OTHER OPERATING REVENUE. In 1998, other operating revenue increased by $1.6 million over 1997. The increase is due primarily to an increase in balancing charges and various miscellaneous fees charged to customers beginning in late 1997.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
GAS DISTRIBUTION (CONT.)
OPERATING EXPENSES. Operating expenses decreased by $2.7 million (or 5%) in 1998 when compared to 1997. Approximately $1.9 million of the decrease is attributable to an overall reduction in general and administrative expenses due to cost cutting measures initiated during 1998, lower incentive compensation due to the decrease in Company earnings, and reductions in compensation and pension expenses due primarily to lower employee levels as a result of the Company's early retirement program and changes to the Company's employee pension plans. See Note 9 in the Notes to the Consolidated Financial Statements for more information on the early retirement program. In addition, there were decreases in uncollectible gas accounts ($.4 million) due to increased collection efforts and warmer weather, regulatory expenses ($.4 million) due to a reduced regulatory activity, and insurance costs ($.5 million) due primarily to efforts to reduce premiums while maintaining coverage levels. During 1998, the Gas Company also recorded a one-time $.4 million reduction in employee benefit expenses as a result of the early retirement program. These savings were offset partially by increases in depreciation expense as a result of new property, plant and equipment placed in service and increases in retiree medical expense. The 1997 rate case authorized a customer rate increase to offset the impact of the additional retiree medical expense. In 1997, operating expenses increased by $.8 million (or 1%) when compared to 1996. The increase was attributable mainly to increases in depreciation and property tax expenses ($1.2 million) due to additional property, plant and equipment in service, an increase in uncollectible gas accounts resulting from the previous year's colder weather and higher gas prices, and a slight increase in retiree medical costs. Partially offsetting these increases were decreases in pension and employee benefit expenses.
OUTLOOK. The strategy of the Gas Company is to maximize its earnings potential. With the approval of incentive rates by the MPSC in late 1997 and 1998, the Gas Company is allowed to retain a portion of earnings in excess of its authorized return and refund the remainder to customers. In 1998, the MPSC also authorized the Gas Company to, among other things, suspend its GCR clause and freeze for three years in its base rates a gas charge of $3.24 per Mcf. The GCR freeze and new rates take effect in April 1999 and generally extend through March 2002. The Gas Company was able to offer this GCR suspension partly as a result of agreements reached with TransCanada Gas Services, Inc., under which the latter will provide the Gas Company's natural gas requirements and manage the Gas Company's natural gas supply and the supply aspects of transportation and storage operations for the same three year period. Management believes that the overall impact of the MPSC order and the Gas Company's agreements with TransCanada will be lower rates for its customers and an opportunity for the Company to increase profitability while maintaining or improving service levels (see Note 2 of the Notes to the Consolidated Financial Statements).
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
GAS DISTRIBUTION (CONT.)
The Gas Company's 3% customer growth rate in 1998 was nearly double the industry average and is anticipated to continue. Efforts to offer new products and services will continue. Control of operating expenses will be enhanced through the early retirement program offered during 1998, the redesign of employee benefits during 1998 and increased use of technology to achieve operating efficiencies. These technologies include automatic meter reading and automated dispatch and scheduling. Through more effective management of the construction budget and financing costs, growth in capital costs are expected to be contained. As is the case with many gas distribution utilities, there is a potential for industrial and generating plants on the Gas Company's system to bypass the Gas Company and connect directly to interstate natural gas pipelines. Refer to the Industry Trends section in the following pages for more information. For information on environmental matters, regulatory matters and the application of SFAS 71, "Accounting for the Effects of Certain Types of Regulation", refer to Notes 2 and 14 of the Notes to the Consolidated Financial Statements.
ENGINEERING SERVICES
SIGNIFICANT GROWTH IN ENGINEERING REVENUES AND EARNINGS. The Company's engineering services business segment ("Engineering Services") contributed $41.4 million in revenues and $2.9 million in operating income for 1998. Engineering Services is comprised of two companies, Maverick Pipeline Services, Inc. ("Maverick") and Oilfield Materials Consultants, Inc. ("OMC"). The acquisition of Maverick, in December 1997, was accounted for as a purchase. Therefore, the consolidated financial statements and the table below include the results of Maverick's operations since December 1997. The acquisition of OMC, in November 1998, was accounted for as a pooling of interests and, accordingly, the consolidated financial statements and the table below have been restated to include the financial results of OMC as if it were part of the Company for all of 1998, 1997 and 1996 (see Note 3 of the Notes to the Consolidated Financial Statements).
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
ENGINEERING SERVICES (CONT.)
ENGINEERING REVENUES. Engineering Services' operating revenues in 1998 increased $35.7 million or nearly eight-fold from 1997. Approximately $24.5 million of the increase represents the 1998 revenues of Maverick, which was acquired in December 1997. Maverick's revenues reflect a $20 million turnkey project it completed in Vineland, New Jersey. Maverick performed the engineering and design-work and also managed construction of the project. Maverick was able to win the turnkey project due, in part, to the financial strength of SEMCO Energy, Inc. The remainder of the increase in 1998 engineering revenues ($11.2 million), when compared to 1997, is attributable to OMC. OMC's 200% increase in revenues is due to growth in OMC's customer base and growth in quality assurance and quality control projects worked on in 1998. In 1997, engineering revenues increased by $2.7 million (or 90%) compared to 1996. The increase was due to growth in OMC's customer base, which led to increased revenue from quality assurance projects in the natural gas pipeline industry.
OPERATING EXPENSES. In 1998, operating expenses increased by $33.5 million, when compared to 1997. $23.1 million of the increase is Maverick's 1998 operating expenses. $10.4 million of the increase is attributable to OMC and represents increases in the level of business experienced in 1998. Operating expenses increased by $2.2 million (or 82%) in 1997 compared to 1996. The increase is due primarily to increases in compensation, payroll taxes and project expenses to support the increase in revenues.
OUTLOOK. Management plans to expand Engineering Services by growing its existing operations and through acquisitions. Management believes there is a trend towards outsourcing in the utility industry and believes that Engineering Services is positioned to take advantage of this trend. It is also anticipated that the demand for turnkey services will increase. With the financial strength of SEMCO Energy, Inc., Engineering Services is in a position to win significant turnkey projects. Engineering Services successfully completed its first turnkey project in 1998 and expects to expand this type of business significantly in the future. With the recent downturn in oil prices, there has been a reduction in oil and gas production and related activities, as a result of which OMC has experienced a reduction in the level of available construction inspection and quality assurance projects. Management believes that the level of these activities and available projects will increase as oil prices recover.
CONSTRUCTION SERVICES
CONSTRUCTION BUSINESS EXPANDS. The construction services business segment ("Construction Services") expanded into Tennessee with the acquisition of King Energy & Construction Co. ("King") in May 1998. King provides underground construction services similar to those provided by Sub-Surface Construction Co. ("Sub-Surface"). Construction Services also started an overhead-line construction company in Florida in January 1998. However, the operations of this start-up business were halted in mid-1998 in resp-onse to lower than expected business levels and earnings. The start-up business generated an operating loss of $.9 million during the period it operated.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
CONSTRUCTION SERVICES (CONT.)
OPERATING INCOME. Construction Services' operating income, excluding the start-up business mentioned above, was $.8 million in both 1998 and 1997. The 1997 results reflect the operations of Sub-Surface for the period subsequent to its acquisition in August 1997, which excludes the seasonal losses which are typical during the first half of the year.
OUTLOOK. Management believes there are significant opportunities for growth in the pipeline construction industry. The industry is viewed as large but highly fragmented. Management believes that customer preference is shifting from smaller construction companies to much larger contractors. The Company plans to expand Construction Services' market share significantly by acquiring established companies that have a strong customer base.
PROPANE, PIPELINES AND STORAGE
PROPANE COMPANY ACQUIRED. The Company entered the propane distribution business with the acquisition of Hotflame Gas, Inc. and Hot Flame Transport Co., Inc. (together "Hotflame") on March 31, 1998. The acquisition of Hotflame was accounted for as a purchase and, therefore, only the results of operations since April 1998 are included in the consolidated financial statements and the table below. Hotflame's 1998 operating results do not include the very profitable winter heating months of January through March. The operating results of the Company's pipelines and storage operations have been fairly consistent over the past three years. The operations consist of several pipelines and an ownership interest in a gas storage facility (separate from the Gas Company), all of which are located in Michigan.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
PROPANE, PIPELINES AND STORAGE (CONT.)
OPERATING REVENUES. Operating revenues were $4.8 million in 1998 compared to $3.0 million in 1997. The increase was due primarily to the propane distribution revenue recorded in 1998 for Hotflame.
OPERATING INCOME. Operating income was generally unchanged with nearly all income coming from the pipeline and storage operations. The propane operation did not contribute any operating income due to the combination of the warm weather (19% warmer than normal in the Company's propane market area) and the fact that the operating results did not include operating income from the profitable winter heating months of January through March. On a weather-normalized basis, the propane operation would have contributed $.2 million to operating income for the period of April through December of 1998.
OUTLOOK. Management's goal is to build a strong regional propane business. Growth will be focused in the Midwest and regions contiguous to the Company's existing propane or natural gas operations. Hotflame is currently the largest provider of propane in the upper peninsula of Michigan. Through prudent acquisitions, management will attempt to double or triple the size of the Company's propane operation over the next five years. Management believes that the gas pipelines and storage operations could experience opportunities for growth with the increased deregulation of gas markets. As gas markets continue to expand, management feels that the quantity of gas moving through the Great Lakes Region will increase, therefore, creating additional pipeline and storage opportunities.
ENERGY MARKETING
On March 15, 1999, the Company entered into an agreement, subject to approval under the Hart-Scott-Rodino Anti-Trust Improvements Act of 1987, to sell its energy marketing business ("Energy Services") to another energy marketer. Management has concluded that the relatively low margins, generally poor industry returns and high risks associated with natural gas marketing do not support remaining in the business. The gas marketing business no longer fits the Company's future strategic direction.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
ENERGY MARKETING (CONT.)
GAS MARKETING MARGIN. Gas marketing margin for 1998 decreased by $4.7 million when compared to 1997 due primarily to the impact of warm weather on market demand, increased competition, restructuring activities at Energy Services and a decrease in gas marketing volumes. The warm weather reduced prices which decreased gas marketing margins. Increased competition also continued to put downward pressure on gas marketing margins. During 1998, Energy Services terminated agreements with all of its third-party gas marketing companies in an effort to reduce risks, eliminate lower margin transactions and improve profitability. The termination of these agreements accounts for a portion of the decrease in gas marketing volumes when compared to 1997. In 1997, natural gas marketing revenues and volumes increased $211 million (or 61%) and 70,260 MMcf (or 54%), respectively, when compared to 1996. Revenues and volumes increased significantly due to the development of additional marketing offices. The $8.7 million increase in gas marketing margin in 1997, when compared to 1996, was due to the impact on 1996 results of uneconomical trading contracts which Energy Services has since terminated.
OPERATING EXPENSES. Operating expenses decreased by $3.8 million (or 44%) in 1998, compared to 1997, due to lower incentive payments to the Company's third-party gas marketers and the termination of gas marketing agreements with these companies as discussed above. In 1997, operating expenses increased $4.6 million (or 118%) when compared to 1996. The increase was due to larger third-party marketer incentive payments relating to higher margins ($2.2 million), additional expenses to support increased gas marketing volumes ($1.1 million), increased receivables write-offs ($.6 million) and other restructuring charges and taxes ($.7 million).
OTHER INCOME AND DEDUCTIONS
DIVESTITURE OF NOARK INVESTMENT. On January 14, 1998, the Company sold its entire interest in the NOARK Pipeline System Partnership ("NOARK") to ENOGEX Arkansas Pipeline Corporation ("EAPC"). Refer to Note 15 of the Notes to the Consolidated Financial Statements for additional information regarding NOARK.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
OTHER INCOME AND DEDUCTIONS (CONT.)
In December 1996, the Company recorded a $21.0 million after-tax non-cash write-down of its general partnership interest in NOARK. In December 1997, the Company reduced its reserve for NOARK by $5.0 million after-tax based on the terms of the pending sale. The sale occurred in January 1998 and, including subsequent adjustments, resulted in a final gain on the sale of NOARK of $1.7 million after-tax. The adjustments to the gain included income tax benefits related to tax losses generated by the partnership and adjustments to discount rates used to compute the present value of future cash flows pursuant to the terms of the sale. The discount rates were adjusted to better reflect actual market rates at the time of the sale.
INTEREST EXPENSE. Interest expense increased by $1.7 million (or 13%) in 1998 compared to 1997 due to the higher levels of debt outstanding during the first half of 1998. The additional debt had been incurred to finance the Company's ongoing capital expenditure program and for general corporate purposes. During August 1998 the Company sold 1.82 million shares of its common stock and used a significant portion of the net proceeds to repay short-term debt. See Note 5 of the Notes to the Consolidated Financial Statements for more information on debt issuances and refinancings. Interest expense increased by $2.0 million (or 18%) in 1997 compared to 1996 due primarily to increases in debt levels to finance the Company's capital expenditure program and for general corporate purposes.
OTHER. In 1998, other income increased by $.6 million when compared to 1997. The increase is due primarily to the impact of discontinuing the Company's unprofitable appliance merchandising programs in 1997 and an increase in equity income from partnership investments in gas pipeline and gas storage facilities. Other income increased by $1.4 million from 1996 to 1997. The increase is attributable mainly to the change in accounting treatment for NOARK in 1996. With its write-down of NOARK in December 1996, the Company discontinued accounting for NOARK under the equity method and stopped accruing interest income on advances to the NOARK partnership.
ACCOUNTING METHOD CHANGE AND EXTRAORDINARY ITEM
The Company changed its method of accounting for property taxes during 1998. The cumulative effect of the change in accounting method increased earnings by $1.8 million. The Company also incurred an extraordinary charge of $.5 million after-tax during 1998 for the early redemption of all of its outstanding 8.625% debentures due April 15, 2017. Refer to Note 1 of the Notes to the Consolidated Financial Statements for more information on these items.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
LIQUIDITY AND CAPITAL RESOURCES
CASH FLOWS FROM INVESTING. The Company's single largest use of cash is capital investments. The following table identifies investments for the past three years:
Capital expenditures for gas distribution represent primarily new customer additions and, to a lesser extent, plant repair and replacement. In addition, the Company invested approximately $4.5 million, $8 million and $2 million in technology in 1998, 1997 and 1996, respectively. This technology consists of automated meter reading, automated dispatch and scheduling, in-truck computer terminals and other computer infrastructure improvements which are expected to increase significantly customer service and operational efficiency at the gas distribution operation. In 1999, the Company plans to spend approximately $20 million on property additions for the gas distribution and diversified businesses. In addition, the Company is planning to incur additional expenditures for business acquisitions in 1999.
CASH FLOWS FROM OPERATIONS. The Company's net cash provided from operating activities totaled $24.7 million in 1998, $9.0 million in 1997, and $11.4 million in 1996. The change in operating cash flows is significantly influenced by changes in the level and cost of gas in underground storage, changes in accounts receivable and accrued revenue and other working capital changes. The changes in these accounts are largely the result of the timing of receipts and payments. The Company uses significant amounts of short-term borrowings to finance natural gas purchases for storage during the non-heating season. The Company owns and leases natural gas storage facilities with available capacity approximating 35% to 40% of average annual gas sales. Generally, gas is stored during the months of April through October and withdrawn for sale from November through March. The carrying amount of natural gas stored underground peaked at $58 million, $59 million, and $38 million in October 1998, 1997, and 1996, respectively.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
LIQUIDITY AND CAPITAL RESOURCES (CONT.)
CASH FLOWS FROM FINANCING. The Company raised $6.2 million by issuing new common shares during 1998 to meet the dividend reinvestment and stock purchase requirements of the DRIP. In April 1998 the Company redeemed all of its outstanding 8.625% debentures due April 15, 2017. The redemption was accomplished using short-term debt. The Company and SEMCO Capital Trust filed a registration statement on Form S-3 ("registration statement") with the Securities and Exchange Commission ("Commission") in July 1998 for the registration of debt securities and common stock of the Company and trust preferred securities of SEMCO Capital Trust in any combination up to $200 million. During August 1998 the Company sold 1.82 million shares of its common stock in a public offering. The proceeds of the offering were $26.2 million after underwriting discounts but before expenses. The Company used the net proceeds from the stock issuance to repay short-term debt and for general corporate purposes. In October 1998, the Company entered into a Distribution Agreement with Merrill Lynch & Co., Morgan Stanley Dean Witter, A.G. Edwards & Sons, Inc. and Edward D. Jones & Co., L.P. pursuant to which it may issue, from time to time, an aggregate of $150 million of medium-term notes. The Company issued, in November 1998, $5 million of 6.40% medium-term notes due November 2008, $15 million of 6.50% medium-term notes due November 2005, and $10 million of 7.03% medium-term notes due November 2013. During 1998, the Company made a $9.2 million payment on a note payable to EAPC pursuant to the terms of the sale of NOARK (See Note 15 of the Notes to the Consolidated Financial Statements). The Company issued 1.3 million shares of its common stock to the shareholders of businesses acquired during 1998. Of the shares issued, .9 million were for the acquisition of OMC which was accounted for as a pooling of interests. See Notes 1 and 3 of the Notes to the Consolidated Financial Statements for more information. Dividends paid to common shareholders increased from 1996 through 1998 due to the impact of 5% stock dividends in each of those three years. The stated cash dividend of $.20 per share per quarter did not change. However, the acquisition of OMC was accounted for as a pooling of interests and, accordingly, the 1998, 1997 and 1996 dividends paid have been restated to include the dividends paid by OMC.
FUTURE FINANCING. In general, the Company funds its capital expenditure program and dividend payments with operating cash flows and the utilization of short-term lines of credit. When appropriate, the Company will refinance its short-term lines with long-term debt, common stock or other long-term financing instruments. The Company expects to acquire additional businesses in 1999 and will likely raise the required capital through a combination of utilizing short-term lines of credit and issuing long-term debt or equity. At December 31, 1998, the Company had $110 million of short-term credit facilities, of which $50.2 million was unused.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
LIQUIDITY AND CAPITAL RESOURCES (CONT.)
During 1999, the Company will make a $3.1 million payment to EAPC pursuant to the terms of the sale of NOARK. See Note 15 of the Notes to the Consolidated Financial Statements for a discussion of the amounts to be paid in conjunction with the sale of NOARK.
COMMODITY HEDGING. Energy Services has entered into various long-term sales commitments which may extend up to 60 months into the future. Energy Services maintains a hedging program with the objective of preserving the anticipated margin on these sales commitments. The hedges are designed to ensure that the impact of natural gas price fluctuations on the fair value of long-term sales commitments will be offset by gains and losses on the hedging instrument. The most frequently used hedging instruments are natural gas futures and options, although Energy Services may also enter into natural gas swap agreements, enter into contracts to purchase natural gas from producers for future delivery or inject gas into storage for later withdrawal. Critical to the success of the hedging program is the performance by both the party to the hedge and the marketing customer buying gas under the long-term sales commitment. Energy Services performs extensive credit reviews on new and existing marketing customers and only enters into hedging transactions with reputable dealers, primarily on the NYMEX, or directly with reliable suppliers. At December 31, 1998 and 1997, Energy Services had recorded net deferred gains (losses) from its hedging program of approximately ($3.3 million) and $.1 million, respectively. At the same time, Energy Services had offsetting amounts of unrecorded gains or losses pursuant to the underlying long-term sales commitments. See Note 8 of the Notes to the Consolidated Financial Statements for further information regarding the types, underlying notional volumes, and fair values of Energy Services' hedges at December 31, 1998 and 1997.
MARKET RISK INFORMATION. The market risk inherent in the Company's market risk sensitive instruments and positions is the potential loss arising from adverse changes in natural gas prices. The prices of natural gas are subject to fluctuations resulting from changes in supply and demand. To reduce price risk caused by these market fluctuations, the Company's policy is to hedge (through the use of derivatives) inventory and related purchase and sale contracts. Because commodities covered by these derivatives are substantially the same commodities that the Company buys and sells in the physical market, no special correlation studies other than monitoring the degree of convergence between the derivative and cash markets, are deemed necessary. (The changes in market value of these financial instruments have a high correlation to the price changes of natural gas.)
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
LIQUIDITY AND CAPITAL RESOURCES (CONT.)
A sensitivity analysis has been prepared to estimate the price exposure to the market risk of the Company's natural gas commodity position. The Company's monthly net commodity position consists of natural gas inventories, purchase and sale contracts, and derivative financial and commodity instruments. The fair value of this position is a summation of the fair value of each position calculated by valuing each net position at quoted futures prices. Market risk is estimated as the potential loss in fair value resulting from a hypothetical 25% adverse change in such prices over the next 12 months. The results of this analysis, which may differ from actual results, showed that this type of change would reduce the market value of the Company's net commodity position by less than $50,000.
IMPACT OF INFLATION
The cost of gas sold by the Gas Company is recovered from natural gas distribution customers on a current basis through its GCR clause. However, the MPSC has authorized the Company to suspend its GCR clause and freeze for three years in its base rates a gas charge of $3.24 per Mcf. The GCR suspension and rate freeze take effect in April 1999 and generally extend through March 2002. See Note 2 of the Notes to the Consolidated Financial Statements for more information regarding the rate freeze. Increases in other utility operating costs are recovered through the regulatory process of a rate case and, therefore, may adversely affect the results of operations in inflationary periods due to the time lag involved in this process. The Company attempts to minimize the impact of inflation by controlling costs, increasing productivity and filing rate cases on a timely basis.
INDUSTRY TRENDS
COMPETITION. The market prices of alternate sources of energy such as coal and #6 fuel oil compete to a limited degree with the price the Gas Company charges for industrial sales and transportation of natural gas. To lessen the possibility of a fuel switch by industrial customers, the Company offers additional services, such as gas storage and balancing, in addition to a more environmentally friendly fuel.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
INDUSTRY TRENDS (CONT.)
The Gas Company serves a number of industrial and generating plants on various parts of its system. Some of these plants are also located in the vicinity of interstate natural gas pipelines. As is the case with many local gas distribution utilities, the Gas Company is subject to being bypassed by these pipelines. In response to this threat, the Gas Company, from time to time, enters into agreements with companies under which the Gas Company may reduce the rates it charges for transportation of natural gas to the companies' plants, in return for which the plants will continue to use the Gas Company system for all of their requirements for natural gas distribution and transportation service, and not connect directly to the pipelines. The Gas Company is currently negotiating agreements with two plants. There can be no assurance that other plants located on the Gas Company's system and accessible to interstate pipelines will not also seek to take advantage of bypass opportunities in the future. Engineering Services competes with regional, national and international firms as well as in-house engineering and field service departments. Because of the minimal initial capital requirements it is likely that new competition will arise from other firms that possess the professional requirements and qualifications. Success in the engineering services market depends on factors such as technical expertise, experience, price, financial stability and the availability of skilled, technical personnel possessing required industry qualifications. On the basis of these factors, the Company believes it will compete favorably. With the recent downturn in oil prices, there has been a reduction in oil and gas production and related activities, as a result of which OMC has experienced a reduction in the level of available construction inspection and quality assurance projects. Management believes that the level of these activities and available projects will increase as oil prices recover. Construction Services competes with small- and medium-size regional utility contractors who provide similar services and utilize comparable equipment and installation techniques. There is also competition from in-house construction crews of the existing or prospective customers. The Company believes that its level of expertise, experience and resources will allow it to compete favorably in the construction industry. The Company's retail propane business competes with other energy sources such as natural gas, fuel oil and electricity. There is also competition from other regional propane providers. Expansion of natural gas service into propane markets is inhibited due to the capital costs involved in the pipeline infrastructure. Propane is less expensive to use than electricity and conversion of appliances from one fuel to another is costly thereby protecting existing propane markets. The basis of competition with other regional propane providers is price and service. Based on the Company's history of providing safe, reliable and timely service to its customers, the Company believes it will compete favorably with other propane providers. Energy Services competes based on its ability to access competitively priced natural gas and efficiently utilize the pipeline transmission system. Price is the prominent competitive factor in sales to wholesale customers, such as gas distribution companies and municipalities. In retail activities, Energy Services competes based on its ability to offer a broad range of competitively priced products and services that are tailored to meet the needs of individual customers.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
INDUSTRY TRENDS (CONT.)
REGULATION. Since 1994 interstate pipelines have unbundled their services to offer separate service for gas transportation, storage and gathering. As a result, natural gas distribution companies have the ability to select and pay for only those pipeline services they require. In addition, customers on natural gas distribution systems may purchase the same level of unbundled service directly from the interstate pipelines. Under such circumstances, natural gas distribution companies generally provide transportation services to those customers. The availability of unbundled pipeline services has resulted in continued pressure on gas distribution companies to offer similar unbundled services in order to facilitate the customers' choice of possible suppliers. This competition has resulted in some reduction in natural gas transportation margins. Currently, the Gas Company is providing transportation services principally to large industrial and commercial customers.
YEAR 2000
STATE OF READINESS. The Company uses computer systems, equipment, software and related devices ("technology systems") that have date-sensitive embedded technology that may not be able to distinguish between the year 1900 and the year 2000 ("Y2K"). If not corrected, this could cause the Company to, among other things, report inaccurate data, issue inaccurate bills or incur gas delivery problems. The Company has initiated an enterprise-wide plan to prepare for Y2K (the "Y2K Plan"). The Y2K Plan has four phases: (i) identification; (ii) remediation; (iii) testing; and (iv) contingency planning. The identification phase includes identification, inventory, assessment, and prioritization plan development for all technology systems. The remediation phase involves the upgrading, modification, or replacement of technology systems. The testing phase includes testing the remediated technology systems to ensure that they accurately handle the year 2000 date and monitoring the remediated systems to ensure that Y2K problems are not reintroduced. The contingency planning phase involves the development of contingency plans to address certain risk scenarios. The Y2K Plan is being used for traditional information technology ("IT") which includes essential business systems such as payroll, billing, accounting systems, wide area networks, local area networks, personal computers, etc. The Company is also using the Y2K Plan for process control computers and embedded systems contained in buildings, equipment and the gas supply and delivery systems. The Company has completed the identification phase for all significant internal technology systems and is currently in the remediation and testing phases on most of its Y2K projects. The Company currently plans to complete the remediation phase for all significant internal technology systems by July 1999 and complete the testing phase by September 1999, with continuous monitoring of tested systems through the end of 1999. The Company is in the early stages of contingency planning for its Y2K projects and plans to be completed with all contingency planning by November 1999.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
YEAR 2000 (CONT.)
The Company has inquired of third parties, i.e., vendors, suppliers and customers, which have a material relationship with the Company, as to the status of their Y2K readiness. To date, the Company has not received all of the responses from these third parties and, therefore, is unable to state with reasonable assurance the status of their readiness for Y2K. The Company continues to work with critical vendors, suppliers and customers to gain assurance of their Y2K readiness, and will develop contingency plans to mitigate anticipated shortcomings in their readiness.
COST OF REMEDIATION. The Company is expensing the cost of modifications to technology systems as incurred, while capitalizing and amortizing the cost of new software over its useful life. The Company estimates that the total cost of the Y2K Plan is approximately $2.0 to $2.5 million. Costs incurred through December 31, 1998 related to the Y2K Plan were approximately $1.3 million, with the majority of the work being performed by Company employees. The Company has incurred an opportunity cost for implementing the Y2K Plan, thus deferring potentially beneficial IT projects.
RISK ASSESSMENT. The Company has identified what it believes are the most significant worst case Y2K scenarios. These scenarios are (i) interference with the Company's ability to receive and deliver gas to customers and perform services for customers; (ii) interference with the Company's ability to monitor gas pressure and safety throughout the Company's gas distribution system; (iii) interference with communications during safety related emergencies and (iv) interference with the Company's ability to bill and receive payments from customers. These scenarios could result in the Company not being able to deliver gas or perform other services for a period of time, which could have a material adverse effect on the Company's liquidity, financial condition and results of operations. The Company's Y2K Plan is being used to address these worse case scenarios. Contingency plans will be revised and executed to further mitigate the risks associated with these scenarios. The Company expects that its Y2K Plan will be adequate to address its Y2K issues and is developing contingency plans to further assure that vital functions of the Company dependent on third parties will continue uninterrupted. Contingency plans will include existence of short-term in-house capabilities (i.e. back-up power generation) and diversification of goods and services among multiple suppliers (i.e. pipeline companies). However, there are functions, which cannot be duplicated, such as the local telephone network, which remain a vulnerability to the Company. Of course, there can be no assurance as to whether the contingency plans will successfully address all contingencies that may arise. In the event that the Company is unsuccessful in addressing its Y2K issues, there could be a material adverse effect on the Company's liquidity, financial condition and results of operations.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
NEW ACCOUNTING STANDARDS
In June of 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 133 establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. SFAS 133 requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. SFAS 133 is effective for fiscal years beginning after June 15, 1999. The Company has not yet quantified the impacts of adopting SFAS 133 on its financial statements and has not determined the timing of or method of its adoption of SFAS 133. However, SFAS 133 could increase volatility in earnings and other comprehensive income. In December 1998, the Emerging Issues Task Force reached consensus on Issue No. 98-10, "Accounting for Contracts Involved in Energy Trading and Risk Management Activities" ("EITF Issue 98-10"). EITF Issue 98-10 is effective for fiscal years beginning after December 15, 1998. EITF Issue 98-10 requires energy trading contracts to be recorded at fair value on the balance sheet, with the changes in fair value included in earnings. The effects of initial application of EITF Issue 98-10 will be reported as a cumulative effect of a change in accounting principle. Financial statements for periods prior to initial adoption of EITF Issue 98-10 may not be restated. The Company has not yet quantified the impacts of adopting EITF Issue 98-10 on its financial statements but does not anticipate that the accounting change will have a material effect going forward.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONT.)
FORWARD LOOKING STATEMENTS
This Annual Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that are based on current expectations, estimates and projections. Statements that are not historical facts, including statements about the Company's belief and expectations are forward-looking statements. These statements are subject to potential risks and uncertainties and, therefore, actual results may differ materially. The Company undertakes no obligation to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Factors that may impact forward-looking statements include, but are not limited to, the following: (i) the effects of weather and other natural phenomena; (ii) the economic climate and growth in the geographical areas where the Company does business; (iii) the capital intensive nature of the Company's business; (iv) increased competition within the energy marketing industry as well as from alternative forms of energy; (v) the timing and extent of changes in commodity prices for natural gas; (vi) the effects of changes in governmental and regulatory policies, including income taxes, environmental compliance and authorized rates; (vii) the Company's ability to bid on and win business contracts; (viii) the impact of energy prices on the amount of projects and business available to Engineering Services; (ix) the nature, availability and projected profitability of potential investments available to the Company and (x) the conditions of capital markets and equity markets.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The accompanying notes to the consolidated financial statements are an integral part of these statements.
The accompanying notes to the consolidated financial statements are an integral part of these statements.
The accompanying notes to the consolidated financial statements are an integral part of these statements.
The accompanying notes to the consolidated financial statements are an integral part of these statements.
The accompanying notes to the consolidated financial statements are an integral part of these statements.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
SEMCO Energy, Inc., is an investor-owned holding company. SEMCO Energy, Inc. and its subsidiaries (the "Company") operate five business segments. The business segments are gas distribution, engineering services, construction services, energy marketing and propane, pipelines and storage. The Company's gas distribution business segment ("Gas Company") distributes and transports natural gas to nearly 250,000 customers within the state of Michigan. The engineering services segment ("Engineering Services") has offices in New Jersey, Michigan, Louisiana and Texas and provides a variety of energy related engineering services in several states. The construction services business segment ("Construction Services") with offices throughout Michigan and one in Tennessee provides primarily pipeline construction services in Michigan, Tennessee and Florida. The propane, pipelines and storage segment supplies propane to over 7,500 retail customers in Michigan's upper peninsula and northeast Wisconsin and operates natural gas transmission, gathering and storage facilities in Michigan. The energy marketing business segment ("Energy Services") engages in energy marketing to approximately 188 customers located in several states.
POOLING OF INTERESTS. During 1998, the Company acquired Oilfield Materials Consultants, Inc. ("OMC"). The acquisition of OMC was accounted for as a pooling of interests, and accordingly, the consolidated financial statements and notes for the periods presented have been restated to include the financial results of OMC. See Note 3 for further information.
FINANCIAL STATEMENT PRESENTATION. The financial statements of the Company are presented in the conventional classification format rather than a regulated utility format, which has been used in the past. Certain reclassifications have been made to the prior years' financial statements to conform with the 1998 presentation.
USE OF ESTIMATES. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
PRINCIPLES OF CONSOLIDATION. The consolidated financial statements include the accounts of SEMCO Energy, Inc. and its wholly-owned subsidiaries. Investments in unconsolidated companies at least 20% owned, but not greater than 50% owned, are reported using the equity method of accounting.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
1. SIGNIFICANT ACCOUNTING POLICIES (CONT.)
Certain of the Company's nonregulated businesses supply goods and services at a profit to the Company's regulated gas distribution business. In these situations, intercompany profits remaining in the assets of the regulated business at a particular date are not eliminated since it is probable that, through the ratemaking process, the cost will be recovered through future revenue. As a result, $595,000 and $437,000 of profit on sales earned from the Company's regulated business by the Company's nonregulated businesses was not eliminated during consolidation in 1998 and 1997, respectively. All other significant intercompany transactions have been eliminated.
RATE REGULATION. The rates of the Gas Company's customers located in the Battle Creek division are subject to the jurisdiction of the City Commission of Battle Creek, Michigan. The Michigan Public Service Commission ("MPSC") authorizes the rates charged to all of the remaining Gas Company customers.
PROPERTY, PLANT, EQUIPMENT AND DEPRECIATION. The Company's property, plant and equipment ("property") is recorded at cost. The Company provides for depreciation on a straight-line basis over the estimated useful lives of the related property. The ratio of depreciation to the average balance of property approximated 3.9%, 3.6% and 3.6% for the years 1998, 1997 and 1996, respectively. Certain investments in unconsolidated companies recorded using the equity method are reported in the property of the diversified businesses. See Note 13 for further discussion.
GAS IN UNDERGROUND STORAGE. Gas in underground storage for the Gas Company's MPSC division is reported at average cost. The Battle Creek division's gas inventory is stated at last-in, first-out ("LIFO") cost. At December 31, 1998 and 1997, the replacement cost of the Battle Creek division's gas inventory did not exceed the LIFO cost. Energy Services reports gas in storage at average cost. In general, commodity costs and variable transportation costs are capitalized as gas in underground storage. Fixed costs, primarily pipeline demand charges and storage charges, are expensed as incurred through cost of gas.
REVENUE RECOGNITION. The Gas Company bills monthly on a cycle basis and follows the industry practice of recognizing accrued revenue for gas services rendered to its customers but not billed at month end. Engineering Services and Construction Services recognize revenues as services are rendered and recognize accrued revenue for services rendered but not billed at month end. The propane business recognizes propane sales in the same period that the propane is delivered to customers. Energy Services recognizes marketing revenues, and any related hedging gains or losses, in the same period natural gas is delivered to customers. See Note 8 for further discussion about Energy Services' hedging activities.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
1. SIGNIFICANT ACCOUNTING POLICIES (CONT.)
COST OF GAS. The Gas Company has regulator approved gas cost recovery ("GCR") mechanisms which allow for the adjustment of rates charged to customers in response to increases and decreases in the cost of gas purchased. In 1998, the MPSC authorized the Gas Company to suspend its GCR clause and freeze for three years in its base rates a gas charge of $3.24 per Mcf. The GCR freeze and new rates take effect in April 1999 and generally extend through March 2002. As a result of the GCR suspension, customer rates will not be adjusted during the three year period. See Note 2 for more information.
INCOME TAXES. Investment tax credits ("ITC") utilized in prior years for income tax purposes are deferred for financial accounting purposes and are amortized through credits to the income tax provision over the lives of the related property. The Company files a consolidated federal income tax return and income taxes are allocated to each subsidiary based on its separate taxable income.
EXTRAORDINARY CHARGE. During the second quarter of 1998, the Company redeemed all of its outstanding 8.625% debentures due April 15, 2017 at a redemption price of 104% of the principle amount of $23,548,000. The payment of the call premium and the unamortized debt expense associated with the non-regulated operations of the Company is reflected as an extraordinary charge of $499,000 after-tax.
CHANGE IN METHOD OF ACCOUNTING. During the first quarter of 1998, the Gas Company implemented a change in its method of accounting for property taxes so that such taxes are expensed monthly during the fiscal period of the taxing authority for which the taxes are levied. This change provides a better matching of property tax expense with both the payment of services and those services provided by the taxing authority. Prior to 1998, the Company expensed property taxes monthly during the year following the assessment date. The cumulative effect of this change in accounting for property taxes increased 1998 earnings by $1,784,000 after-tax. The pro forma effect on prior years' consolidated net income of retroactively recording property taxes as if the new method of accounting had been in effect for all periods presented is not material.
STATEMENTS OF CASH FLOWS. For purposes of the consolidated statements of cash flows, the Company considers all highly liquid investments purchased with original maturities of three months or less to be cash and temporary cash investments. The Company paid income taxes of $2,100,000, $3,153,000 and $3,275,000 during 1998, 1997 and 1996, respectively. The Company paid $14,423,000, $11,949,000 and $10,566,000 for interest during 1998, 1997 and 1996, respectively.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
1. SIGNIFICANT ACCOUNTING POLICIES (CONT.)
2. REGULATORY MATTERS
SUSPENSION OF GAS COST RECOVERY CLAUSE AND NEW INCOME SHARING MECHANISM. In September 1998, the Gas Company's MPSC division received authority from the MPSC to: (1) implement an experimental residential gas customer choice program; (2) suspend its gas cost recovery ("GCR") clause; (3) roll into its base rates and freeze for three years a gas charge of $3.24 per thousand cubic feet ("Mcf"); (4) freeze distribution rate adjustments for the same three year period, with exceptions; (5) suspend the income sharing mechanism adopted in October 1997 and adopt a new income sharing mechanism for use during the 1999, 2000 and 2001 calendar years; and (6) establish gas service performance criteria. The new rates take effect in April 1999 and generally extend through March 2002. Under the experimental residential gas customer-choice program up to 21,000 residential customers, 10% of the Gas Company's residential customer base, will be allowed to choose their own gas supplier by the third year of the program. The Gas Company will deliver the customer-choice gas under a tariff similar to its existing tariff used to provide such service to its commercial and industrial customers. The Company anticipates that this program will not significantly affect the Gas Company's income because the Gas Company's approved rates for transportation service are designed to recover all costs other than the cost of gas and provide a return in approximately the same amounts as such costs are recovered from residential customers for whom the Gas Company is the supplier.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
2. REGULATORY MATTERS (CONT.)
Several of the changes in the MPSC order are interrelated. The $3.24 GCR rate represents a reduction of approximately $.33 per Mcf from the Gas Company's present rates. The suspension of the GCR clause means that the Gas Company will not be able to recover any amounts by which its gas costs exceed a weighted average cost of gas in excess of the $3.24 GCR for the three year period. If the Gas Company is able to reduce its gas costs below the $3.24 level, a portion of the savings is retained. The Gas Company was able to offer this GCR suspension mainly as a result of agreements reached with TransCanada Gas Services Inc., under which the latter will provide the Gas Company's natural gas requirements and manage the Gas Company's natural gas supply and the supply aspects of transportation and storage operations for the three year period. There are two exceptions to the three year distribution rate freeze: first, the incentive sharing mechanism described in the following paragraph, and second, rate revisions arising in response to unanticipated legislative or accounting actions. The MPSC order is applicable only in the geographic areas subject to the regulatory jurisdiction of the MPSC, and, therefore, does not govern rates regulated by the City of Battle Creek, Michigan. However, the Gas Company is voluntarily reducing its Battle Creek GCR rate to the $3.24 level to correspond with its GCR under the MPSC order. The new income sharing mechanism substantially matches mechanisms approved by the MPSC for two other major natural gas utilities in Michigan. Under the mechanism, if the Gas Company's return on equity for its natural gas utility business exceeds 12.75%, amounts equal to 50% of the excess return between 12.76% and 16.75%, plus amounts equal to 75% of the excess over 16.75% would be credited to customers, i.e., would be reflected prospectively in reduced rates. Four safety and reliability performance measures need to be met in order not to reduce the return on equity threshold used in the income sharing mechanism. Management believes that the overall impact of the MPSC order and the Gas Company's agreements with TransCanada will be lower rates for its customers and an opportunity for the Company to improve service to its customers as well as improve profitability.
SOUTHEASTERN AND MICHIGAN GAS RATE CASE. In October 1997, the MPSC approved the merger of Southeastern and Michigan Gas in a general rate case. This allowed the Company to combine the rate structures, GCR clauses, tariffs, and rules and regulations for those two divisions. It additionally granted a rate increase to the combined divisions, which included the recovery of costs related to a change in accounting for retiree medical benefits. There were also adjustments to other fees and rates as a result of the rate case. Overall, the adjustments offset one another and the rate case did not have a material impact on the Company's results of operations. The MPSC also approved incentive regulation, where profits generated in excess of the authorized rate of return will be shared with the ratepayer. Finally, the MPSC granted the Company the ability to offer its commercial and industrial customers the option to aggregate their demand for gas into a pool and choose a supplier.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
2. REGULATORY MATTERS (CONT.)
STATE PROPERTY TAX REDUCTIONS. In June 1994, the MPSC issued Orders U-10617 and U-10618 to Michigan Gas and Southeastern, respectively. These orders required the companies to offset deferred retiree medical costs with certain reductions in Michigan state property taxes until the MPSC issued a final order in the companies' general rate case, which occurred in October 1997. In accordance with orders U-10617 and U-10618, Michigan Gas and Southeastern have reduced deferred retiree medical costs by a combined total of $553,000 in 1997 and $663,000 in 1996.
REGULATORY ASSETS AND LIABILITIES. The Gas Company is subject to the provisions of SFAS 71, "Accounting for the Effects of Certain Types of Regulation." As a result, the actions of regulators affect when revenues and expenses are recognized. Regulatory assets represent incurred costs to be recovered from customers through the ratemaking process. Regulatory liabilities represent benefits to be refunded to customers. The following regulatory assets and liabilities were recorded on the consolidated statements of financial position as of December 31 (in thousands of dollars):
In the event the Gas Company determines that it no longer meets the criteria for following SFAS 71, the accounting impact would be an extraordinary, non-cash charge to operations of an amount that could be material. Criteria that give rise to the discontinuance of SFAS 71 include (1) increasing competition that restricts the Gas Company's ability to establish prices to recover specific costs, and (2) a significant change in the manner in which rates are set by regulators from cost-based regulation to another form of regulation. The Gas Company's periodic review of these criteria currently supports the continuing application of SFAS 71.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
3. MERGERS AND ACQUISITIONS
On March 31, 1998, the Company acquired the assets, liabilities and business of Hotflame Gas, Inc. and Hotflame Transport Company, Inc. (together "Hotflame"). Hotflame supplies propane gas to over 7,500 retail customers in Michigan's upper peninsula and northeast Wisconsin. The acquisition was a form of merger whereby the Company exchanged 353,000 shares of its common stock for 100% of the outstanding stock of Hotflame. The fair value of the tangible assets acquired and liabilities assumed were $5,343,000 and $3,074,000, respectively. Included in the assets acquired by the Company were several non-compete agreements with the prior owners of Hotflame totaling $200,000 ranging from two to ten years. The balance of the purchase price, $3,731,000, was recorded as an excess of cost over net assets acquired ("goodwill") and is being amortized on the straight line method over forty years. On May 15, 1998, the Company acquired the assets, liabilities and business of King Energy and Construction, Inc. ("King"). King, which is located in Tennessee, is a multi-utility service provider furnishing water, sewer and natural gas construction services to customers. The acquisition of King was also a form of merger whereby the Company exchanged 18,000 shares of its common stock for 100% of the outstanding stock of King. The fair value of tangible assets acquired and liabilities assumed were $506,000 and $773,000, respectively. The balance of the purchase price, $576,000, is goodwill and is being amortized on the straight line method over forty years. For financial statement purposes, the acquisition of both Hotflame and King were accounted for as purchases and, accordingly, results of operations are included in the consolidated financial statements since the date of each acquisition. There were no adjustments necessary to the accounting practices of Hotflame or King to conform with the practices of the Company. On November 3, 1998, the Company acquired the assets, liabilities and business of Oilfield Materials Consultants, Inc. ("OMC"). OMC is an engineering and consulting firm located in Texas that specializes in quality control and quality assurance services for the natural gas, oil products, exploration/production and telecommunication industries. The acquisition of OMC was also a form of merger whereby the Company exchanged 905,000 shares of its common stock for 100% of the outstanding stock of OMC. The acquisition of OMC was accounted for as a pooling of interests, and accordingly, the consolidated financial statements for the periods presented have been restated to include the financial results of OMC. Operating revenues, extraordinary items, net income (loss) and common shareholders' equity for the individual companies reported prior to the merger were as follows (in thousands of dollars):
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
3. MERGERS AND ACQUISITIONS (CONT.)
For the periods preceding the merger of the Company and OMC, there were no intercompany transactions which required elimination from the combined results of operations and there were no adjustments necessary to conform the accounting practices of the two companies. The Company acquired Maverick Pipeline Services, Inc. ("Maverick") on December 17, 1997. The acquisition was accounted for as a purchase and was included in the Company's 1997 consolidated financial statements. Because Maverick was acquired late in 1997, a complete review of the asset values and liabilities was not complete until 1998. The determination of the final values resulted in a $145,000 increase in goodwill and corresponding increase in liabilities acquired.
4. INCOME TAXES
SFAS NO. 109. The Company accounts for income taxes in accordance with SFAS 109, "Accounting For Income Taxes." SFAS 109 requires an annual measurement of deferred tax assets and deferred tax liabilities based upon the estimated future tax effects of temporary differences and carry forwards.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
4. INCOME TAXES (CONT.)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
4. INCOME TAXES (CONT.)
At December 31, 1998 and December 31, 1997 there was no valuation allowance recorded against deferred tax assets.
5. CAPITALIZATION
REGISTRATION STATEMENT AND DISTRIBUTION AGREEMENT. The Company and SEMCO Capital Trust filed a registration statement on Form S-3 ("registration statement") with the Securities and Exchange Commission ("Commission") in July 1998 for the registration of debt securities and common stock of the Company and trust preferred securities of SEMCO Capital Trust in any combination up to $200 million. In October 1998, the Company entered into a distribution agreement with Merrill Lynch & Co., Morgan Stanley Dean Witter, A.G. Edwards & Sons, Inc. and Edward D. Jones & Co., L.P. pursuant to which it may issue, from time to time, an aggregate of $150 million of medium-term notes, which were included in the securities registered.
COMMON STOCK EQUITY. The Company issued five percent stock dividends in May 1998, May 1997 and May 1996. Earnings per share of common stock, cash dividends per share of common stock and average number of common shares outstanding have been restated to reflect the stock dividends.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
5. CAPITALIZATION (CONT.)
Pursuant to its DRIP, the Company issued 367,000 shares of common stock in 1998 and 298,000 shares in 1997 and 292,000 shares in 1996. The Company did not purchase shares on the open market in 1998 for the DRIP. The Company purchased a total of 162,000 shares in 1997 and 320,000 shares in 1996 for the DRIP. The Company contributed 30,000 shares of Company stock to the Company's primary 401(k) plan in 1998, and 22,000 shares to the Company's Employee Stock Ownership Trust in 1997. During August 1998, the Company sold 1,820,000 shares of its common stock in a public offering. Proceeds of the offering were $26,153,000 after underwriting discounts but before expenses. The proceeds from the common stock issuance were used to repay short-term debt and for general corporate purposes. The Company also issued 1,276,000 and 26,000 shares of its common stock in 1998 and 1997, respectively, as part of certain business acquisitions. Of the shares issued in 1998, 905,000 were for the acquisition of OMC which was accounted for as a pooling of interests. See Notes 1 and 3 for more information on the accounting for a pooling of interests.
CUMULATIVE CONVERTIBLE PREFERRED STOCK. At December 31, 1998 and 1997, only 6,218 and 6,751 shares of the Company's $2.3125 cumulative convertible preferred shares were outstanding and each share was convertible at the option of the holder to 4.11 shares of common stock. At December 31, 1998, a total of 25,556 common shares are reserved for issuance upon conversion of the convertible preferred stock.
CUMULATIVE PREFERRED STOCK OF SUBSIDIARY. The cumulative preferred stock of the Gas Company is callable at the subsidiary's option at $105 per share. Payment of dividends on this preferred stock is fully guaranteed by the Company.
LONG-TERM DEBT. In April 1998, the Company redeemed all of its outstanding 8.625% debentures due April 15, 2017 at a redemption price of 104% of the principle amount of $23,548,000. Later in 1998, the Company issued $30,000,000 of medium-term notes with interest rates ranging from 6.40% to 7.03%. In 1997, the Company issued $60,000,000 of private placement debt to reduce short-term notes payable incurred to finance the Company's ongoing capital expenditure program and for general corporate purposes. The Company has long-term and short-term debt arrangements which contain restrictive financial covenants including, among others, limits on the payment of dividends beyond certain levels. The Company is currently in compliance with all of the covenants in these agreements. There are no annual maturities or sinking fund requirements for the Company's existing debt over the next five years, except for the maturity of $30,000,000 of 6.83% notes in 2002.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
6. SHORT-TERM BORROWINGS
The Company maintains unsecured lines of credit at two banks. Interest on all such lines are at variable rates, which do not exceed the banks' prime lending rates. These arrangements are set to expire during 1999 and the Company expects they will be renegotiated at comparable terms. The Company also has a note payable in connection with the sale of its investment in the NOARK Pipeline System Partnership ("NOARK") (see Note 15).
7. FINANCIAL INSTRUMENTS
FINANCIAL INSTRUMENTS. The following methods and assumptions were used to estimate the fair value of each significant class of financial instruments:
CASH, TEMPORARY CASH INVESTMENTS, ACCOUNTS RECEIVABLES, PAYABLES, AND NOTES PAYABLE. The carrying amount approximates fair value because of the short maturity of those instruments.
LONG-TERM DEBT. The fair values of the Company's long-term debt are estimated based on quoted market prices for the same or similar issues or, where no market quotes are available, based on discounted future cash flows using current interest rates at which similar loans would be made to borrowers with similar credit ratings and remaining maturities. Although the current fair value of the long-term debt may differ from the current carrying amount, settlement of the reported debt is generally not expected until maturity.
HEDGING ARRANGEMENTS. Refer to Note 8 for a description of Energy Services' price hedging arrangements and their fair values.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
8. RISK MANAGEMENT ACTIVITIES AND DERIVATIVE TRANSACTIONS
Energy Services enters into sales commitments which may extend up to 60 months into the future. Because of the volatility of natural gas prices, there are significant market risks associated with these commitments. Energy Services utilizes derivative financial and commodity instruments ("derivatives"), including futures contracts, options and swaps, to reduce market risk associated with fluctuations in the price of natural gas. The derivatives are utilized to ensure that the impact of natural gas price fluctuations on the fair value of long-term sales commitments will be offset by gains and losses on the hedging instrument. Energy Services' risk management policy prohibits the utilization of derivatives for trading purposes. Gains or losses on derivatives associated with firm commitments are recognized as adjustments to the cost of sales or revenues when the associated transactions affect earnings. Gains and losses on derivatives associated with forecasted transactions are recognized when such forecasted transactions affect earnings. If a derivative instrument is terminated early because it is probable that a transaction will not occur, any gain or loss as of such date is immediately recognized in earnings. If a derivative is terminated early for other economic reasons, any gain or loss as of the termination date is deferred and recorded when the associated transaction or forecasted transaction affects earnings. If a derivative is sold or matures, any gain or loss is deferred and recognized as adjustments to the cost of sales or revenues when the associated transaction affects earnings. In order to meet the criteria for the gains and losses on derivatives to be deferred and recognized in the same period as the physical transaction, the commodity must expose the Company to price risk and the derivative used as a hedging instrument must reduce that exposure. Because the commodities covered by the derivatives are substantially the same commodities that the Company buys and sells in the physical market, there is a high degree of correlation between price changes in the derivative and cash markets. If those criteria were not met, the derivative would be marked to market and any change in market value would be recognized in earnings in the period of change. Energy Services is also subject to credit risks due to the volume of large transactions it enters into with third parties. Energy Services maintains credit policies that management believes significantly minimizes the overall credit exposure. These policies include an evaluation of the potential parties' financial condition and the use of standardized agreements which allow for netting of positive and negative exposures associated with a single party. While notional amounts listed below are used to express the volume of various derivatives, those amounts do not generally represent the amounts exchanged by the parties and, thus, are not a measure of the exposure to the Company. The amounts subject to credit risk are substantially smaller. Energy Services does not anticipate any material impact to its financial position or results of operations as a result of non-performance by third parties.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
8. RISK MANAGEMENT ACTIVITIES AND DERIVATIVE TRANSACTIONS (CONT.)
Energy Services estimates the fair value of the derivatives by using available market data and valuation methodologies. Some judgment is required in interpreting market data, and the use of market assumptions or estimation methodologies may affect the estimated fair value amounts. In addition to the unrealized gains and losses on open contracts shown in the table above, Energy Services had approximately $2,202,000 and $782,000 in net deferred gains on contracts closed prior to December 31, 1998 and December 31, 1997, respectively, related to sales commitments in the following month. The deferred gains and losses on both the open and closed contracts are included in other current assets. Energy Services also had margin deposits of $3,923,000 and $4,890,000 as of December 31, 1998 and 1997, respectively, which are also included in other current assets. The cost of margin deposits approximates fair value. Energy Services also hedges certain of its sales commitments with gas held in storage. At December 31, 1998 and 1997, Energy Services held approximately 3,829,000 Mcf and 4,027,000 Mcf in storage with a carrying value of $8,879,000 and $10,364,000, respectively. At December 31, 1998 and 1997, Energy Services also had approximately 888,000 Mcf and 3,055,000 Mcf of outstanding gas loans owed to third parties with a carrying value of $2,286,000 and $6,614,000, respectively.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
9. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
9. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS (CONT.)
PENSIONS. Pension plan benefits are generally based upon years of service and compensation during the final years of employment. The Company's funding policy is to contribute amounts annually to the plans based upon actuarial and economic assumptions designed to achieve adequate funding of projected benefit obligations. On December 31, 1997, the pension plans were amended to provide a special frozen benefit to all employees with at least two years of service on December 31, 1997. This special frozen benefit added both three years of service and three years of age to all eligible employees for purposes of computing accrued pension benefits at December 31, 1997. In conjunction with the amendment, the Company offered an early retirement program to all eligible employees with at least two years of service on December 31, 1997. The program was open from January 14, 1998 through February 27, 1998 and offered employees the additional options of receiving either a lump-sum pension benefit payment or an immediate annuity commencing April 1, 1998. One hundred and one employees accepted the early retirement offer. As a result of the early retirement program and in accordance with the provisions of SFAS 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits", the Company incurred a one-time gain which reduced 1998 net periodic pension costs by $1,641,000. This reduction was partially offset by a one-time charge in the net retiree medical costs discussed below.
OTHER POSTRETIREMENT BENEFITS. The Company provides certain medical and prescription drug benefits to qualified retired employees, their spouses and covered dependents. Retirees with less than 30 years of service are required to contribute from 5% to 50% of the Company's coverage cost, with the percentage depending on the retiree's age and years of service. The Company accounts for retiree medical benefits in accordance with SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This standard requires the full accrual of such costs during the years that the employee renders service to the Company until the date of full eligibility.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
9. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS (CONT.)
In December 1992, the MPSC issued a generic order addressing the adoption of SFAS 106 by utilities under its jurisdiction. The order allows Michigan utilities to adopt SFAS 106 for accounting and ratemaking purposes, subject to a final order in a general rate case and requires the external funding for amounts recovered in rates. The general rate case approved by the MPSC in October 1997 allowed for such recovery of retiree medical benefits, as discussed in Note 2. The City Commission of Battle Creek allowed the recovery of retiree medical benefits in Battle Creek's December 1995 rate increase. Prior to getting rate approval for the Gas Company's portion of retiree medical costs, the Company deferred, as a regulatory asset, those amounts not funded externally. After receiving rate approval for recovery of such costs, the Company began amortizing, as retiree medical expense, the amounts previously deferred. In 1998, 1997 and 1996, the Company expensed retiree medical costs of $3,897,000, $2,471,000 and $2,058,000, respectively. The 1998 retiree medical expense includes a one-time charge of $1,298,000 related to the early retirement program and $899,000 of amortization of previously deferred retiree medical costs. In 1997 and 1996, the Company's retiree medical expense included $553,000 and $663,000, respectively, of deductions pursuant to certain MPSC orders regarding the reduction in Michigan state property taxes. See Note 2 for further discussion of these MPSC orders. In 1997 and 1996, the Company also deferred, and recorded as a regulatory asset, $304,000 and $496,000, respectively of retiree medical costs. The Company established a Voluntary Employee Benefit Association ("VEBA") trust in 1997 to fund its retiree medical benefits and contributed $2,339,000 and $2,023,000 to the trust in 1998 and 1997, respectively. Previously, and to a lesser extent in 1998, the Company had partially funded retiree medical benefits on a discretionary basis through an Internal Revenue Code Section 401(h) account. In 1998, 1997 and 1996, the Company made cash contributions to the 401(h) account of $124,000, $508,000 and $744,000, respectively. The 1998 costs were developed based on the health care plan in effect at January 1, 1998. As of December 31, 1998, the actuary assumed that retiree medical cost increases would be 7.8% and prescription drug cost increases would be 10.3% in 1999 and both would decrease uniformly to 5.0% in 2005 and thereafter. At December 31, 1997, the actuary assumed that retiree medical cost increases would be 8.2% and prescription drug cost increases would be 11.3% in 1998 and both would decrease uniformly to 5.0% in 2005 and thereafter. The health care cost trend rate assumption significantly affects the amounts reported. For example, a one percentage point increase in each year would increase the accumulated retiree medical obligation as of December 31, 1998 by $4,250,000 and the aggregate of the service and interest cost components of net periodic retiree medical costs for 1998 by $361,000.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
9. PENSION PLANS AND OTHER POSTRETIREMENT BENEFITS (CONT.)
401(K) PLANS AND THE EMPLOYEE STOCK OWNERSHIP TRUST. The Company has a defined contribution plan, commonly referred to as the primary 401(k) plan, covering the employees of certain companies in the controlled group. The Company also has an Employee Stock Ownership Trust ("ESOT") covering approximately the same group of employees. During 1998, the Company merged the assets of the ESOT into the primary 401(k) plan. Under the provisions of the ESOT prior to the merger, Company contributions were discretionary. The Company did not contribute to the ESOT in 1996. In 1997, the Company contributed $400,000 in Company stock to the ESOT. During 1998, in conjunction with the merger of the ESOT, the Company amended its primary 401(k) plan to allow for Company matching contributions made in Company stock. The amount expensed for the Company match provision was $491,000 in 1998. The Company has other 401(k) plans which were acquired through business acquisitions during 1998 and 1997. There were no Company matching contributions to these plans in 1998 or 1997.
10. STOCK-BASED COMPENSATION
At the Company's 1997 annual meeting, the shareholders approved a long-term incentive plan providing for the issuance of up to 500,000 shares of non-qualified common stock options over the next ten years adjusted for any subsequent stock dividends and stock splits. The options are reserved for the executives and directors of the Company and are awarded based upon both the Company's and individual's performance. The options vest at the rate of 33 1/3% per year beginning one year after the date of grant and expire ten years after the grant date. Additionally, pursuant to an executive employment agreement, the Company granted 30,000 and 15,000 common stock options during 1997 and 1996, respectively. These options vest three years after the grant date and expire ten years after the grant date.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
10. STOCK-BASED COMPENSATION (CONT.)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
11. EARNINGS PER SHARE
The Company computes earnings per share ("EPS") in accordance with SFAS 128, "Earnings per Share." SFAS 128 requires the computation and presentation of two EPS amounts, basic and diluted. Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. The computation of diluted EPS is similar to that of basic EPS except that the weighted average number of common shares outstanding is increased to include any shares that would be available if outstanding stock options, warrants, or convertible securities ("dilutive securities") were exercised. Accordingly, income available to common shareholders is also adjusted for any changes to income or loss that would result from the assumed conversion of the dilutive securities. The diluted EPS calculation excludes the effect of stock options when their exercise prices exceed the average market price over the period.
As a result of the loss in 1996, basic loss per share was not adjusted because to do so would be antidilutive.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
12. BUSINESS SEGMENTS
The Company adopted SFAS 131, "Disclosure about Segments of an Enterprise and Related Information," during 1998. SFAS 131 established standards for reporting information about operating segments ("business segments") in annual financial statements and requires selected information in interim financial statements. Business segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, to make decisions on how to allocate resources and to assess performance. The Company's chief operating decision making group is the Chief Executive Officer ("CEO") and certain other executive officers that report directly to the CEO. The operating segments are organized and managed separately because each segment offers different products or services. The Company evaluates the performance of its business segments based on the operating income generated. Operating income does not include income taxes, interest expense, extraordinary charges, changes in accounting method and non-operating income and expense items. Under SFAS 131, an operating segment that does not exceed certain quantitative levels is not considered a reportable segment. Instead, the results of all segments that do not exceed the quantitative thresholds are combined and reported as one segment and referred to as "all other." The Company's construction services business segment and propane, pipelines and storage business segment did not meet these quantitative thresholds and could have been grouped into the "all other" category. However, the Company has decided to voluntarily disclose information on these two business segments because they are an integral part of the Company's strategic plans to grow and diversify the Company. The Company has five business segments. They are gas distribution, engineering services, construction services, energy marketing and propane, pipelines and storage. Refer to Note 1 for a brief description of each business segment. The accounting policies of the operating segments are the same as those described in Note 1 except that intercompany transactions have not been eliminated in determining individual segment results. The following table provides business segment information as well as a reconciliation ("Corporate and other") of the segment information to the applicable line in the consolidated financial statements. Corporate and other includes corporate related expenses not allocated to segments, intercompany eliminations and results of other smaller operations.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
12. BUSINESS SEGMENTS (CONT.)
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
13. INVESTMENTS IN AFFILIATES
14. COMMITMENTS AND CONTINGENCIES
CAPITAL INVESTMENTS. The Company's plans for expansion and improvement of its natural gas delivery system and its other diversified business properties are continually reviewed. Aggregate capital expenditures for property in 1999 are projected at $20,000,000. In addition, the Company is planning to incur additional expenditures for business acquisitions in 1999.
GUARANTEES. On January 14, 1998, the Company sold its entire 32% interest in NOARK. The sale released the Company from all its NOARK guarantees, which related to 40% of NOARK's debt. See Note 15 for more information on NOARK.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
14. COMMITMENTS AND CONTINGENCIES (CONT.)
LEASE COMMITMENTS. The Company leases buildings, vehicles and equipment. The resulting leases are classified as operating leases in accordance with SFAS 13, "Accounting for Leases." Vehicle leases comprise a significant portion of total lease expense. Leases on new vehicles are for a minimum of twelve months. The Company has the right to extend each vehicle lease annually and to cancel the extended lease at any time.
Total lease expense approximated $2,164,000, $2,092,000 and $2,305,000 in 1998, 1997 and 1996, respectively. The annual future minimum lease payments shown in the previous schedule are substantially less than the lease expense incurred in 1996 through 1998 because most of the vehicle leases at December 31, 1998 were on a month-to-month basis and were cancelable at any time. However, management expects to renew or replace substantially all leases.
ENVIRONMENTAL ISSUES. Prior to the construction of major natural gas pipelines, gas for heating and other uses was manufactured from processes involving coal, coke or oil. The Gas Company owns seven sites which formerly housed such manufacturing facilities and expects that it will ultimately incur investigation and remedial action costs at some of these sites, and a number of other sites. The Gas Company has submitted a plan to the appropriate environmental regulatory authority in the State of Michigan for work to begin at one site. The extent of the Gas Company's liabilities and potential costs in connection with these sites cannot be reasonably estimated at this time. In accordance with an MPSC accounting order, any environmental investigation and remedial action costs will be deferred and amortized over ten years. Rate recognition of the related amortization expense will not begin until after a prudence review in a general rate case.
15. DIVESTITURE OF NOARK INVESTMENT
On January 14, 1998, the Company sold its entire interest in NOARK to ENOGEX Arkansas Pipeline Corporation ("EAPC"). NOARK is a 302-mile intrastate natural gas pipeline which experienced significant cost overruns during construction, resulting in higher than expected financing costs. In addition, competition from two interstate pipelines required NOARK to discount its transportation charges to attract volumes to the pipeline. Even with discounted rates, NOARK had operated at less than 65% capacity since its inception in 1992. As a result, NOARK continued to generate losses and its operating cash flows were insufficient to meet principal and interest payments on its debt.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONT.)
15. DIVESTITURE OF NOARK INVESTMENT (CONT.)
In December 1996, the Company recorded a $21,000,000 after-tax non-cash write-down of its general partnership interest in NOARK. In December 1997, the Company reduced its reserve for NOARK by $5,025,000 after-tax based on the terms of the pending sale. The sale occurred in January 1998 and, including subsequent adjustments, resulted in a final gain on the sale of NOARK of $1,708,000 after-tax. The adjustments to the gain included income tax benefits related to tax losses generated by the partnership and adjustments to discount rates used to compute the present value of future cash flows pursuant to the terms of the sale. The discount rates were adjusted to better reflect actual market rates at the time of the sale. Pursuant to terms included in the sales agreement, the Company paid EAPC $9,200,000 in April 1998 and will pay $3,100,000 and $800,000 in April 1999 and 2000, respectively. The sale released the Company from all debt obligations and guarantees related to NOARK. The Company will receive annual payments of $842,000 from EAPC for 17 years beginning in the year 2004.
16. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
In the opinion of the Company, the following quarterly information includes all adjustments necessary for a fair statement of the results of operations for such periods. Earnings and dividends per share of common stock are calculated based upon the weighted average number of shares outstanding during each quarter adjusted for five percent stock dividends in May 1998 and May 1997. The total earnings per share each year may not equal annual earnings per share due to changes in shares outstanding throughout the year. Due to the seasonal nature of the Company's gas distribution business, the results of operations reported on a quarterly basis show substantial variations.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
TO SEMCO ENERGY, INC.:
We have audited the accompanying consolidated statements of financial position and capitalization of SEMCO Energy, Inc. (a Michigan corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, changes in shareholders' investment and cash flows for each of the three years in the period ended December 31, 1998. These financial statements and the schedule referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and schedule 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 consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated 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 SEMCO Energy, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. As discussed in Note 1 of the consolidated financial statements, effective January 1, 1998, the Company changed its method of accounting for property taxes. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in item 14(a)2 is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. The schedule has been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Detroit, Michigan February 4, 1999
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 information appearing under the captions "Information About Directors" in Registrant's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 20, 1999 Annual Meeting of Shareholders is incorporated by reference herein. The executive officers of the Company are William L. Johnson, Sebastian Coppola, Rudolfo D. Cifolelli, Carl W. Porter and Barrett Hatches. Mr. Johnson (age 56) was elected Chairman of the Board of Directors in December 1997. He has been President and Chief Executive Officer of the Company since May 1996. From 1994 to May 1996 he was Chief Executive Officer of Northern Pipeline Construction Company of Kansas City, Missouri, and from 1990 to 1994 he was President, Gas Service Division of Western Resources, Inc. of Topeka, Kansas. Mr. Coppola (age 47) has been Senior Vice President and Chief Financial Officer of the Company since January 1999. He was Senior Vice President of Finance, Treasurer and Investor Relations Officer of MCN Energy Group, Inc., Detroit, Michigan, from September 1994 to December 1998. While at MCN Energy Group, Inc., he was Director of Accounting Services and Investor Relations from October 1988 to August 1994. Mr. Porter (age 49) has been Senior Vice President and Chief Operating Officer of the Company since July 1996. He was Vice President-Gas Utilities of Itron, Inc., Spokane, Washington, from August 1995 to July 1996. From 1992 to 1995 he was Senior Vice President of Operations of New Jersey Natural Gas, Wall, New Jersey, and from 1990 to 1992 he was Vice President of Operations of Western Resources, Inc., Topeka, Kansas. Mr. Cifolelli (age 58) has been Senior Vice President and Chief Information Officer of the Company since November 1998. He was President and Owner of OACIS, Inc., Bloomfield, Michigan from June 1996 to October 1998. While employed by the GENIX Group, a subsidiary of MCN Energy Group, Inc., Detroit, Michigan, he was President and Chief Executive Officer from 1994 to 1996 and President and Chief Operating Officer from 1990 to 1994. Mr. Hatches (age 43) was elected Senior Vice President of Human Resources and Public Affairs of the Company in February 1999. He has been with the Company as Vice President of Human Resources and Public Affairs since February 1997. He was Vice President of V. Robinson & Company, Inc., Kansas City, Missouri, from 1996 to February 1997. He was Director of Logistics and Chief Operating Officer H & N Railroad of North American Salt Company, Overland Park, Kansas, from 1995 to 1996. While employed by Missouri Gas Energy, Kansas City, Missouri, he was Director Field Services from May 1994 to January 1995 and Director Customer Information from July 1992 to May 1994.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information appearing under the captions "Compensation of Directors and Executive Officers" and "Compensation Committee Interlocks and Insider Participation" in Registrant's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 20, 1999 Annual Meeting of Shareholders is incorporated by reference herein.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information appearing under the caption "Stock Outstanding, Voting Rights and Votes Required" in the Registrant's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 20, 1999 Annual Meeting of Shareholders, is incorporated by reference herein.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information appearing under the captions "Certain Business Relationships of Directors" and "Employment and Related Agreements" in the Registrant's definitive Proxy Statement (filed pursuant to Regulation 14A) with respect to Registrant's April 20, 1999 Annual Meeting of Shareholders, is incorporated by reference herein.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Consolidated Financial Statements. The following financial statements are included in Part II, item 8 above.
Pages in 10-K -------------
Consolidated Statements of Income for the years ended December 31, 1998, 1997 and 1996 32
Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996 33
Consolidated Statements of Financial Position as of December 31, 1998 and 1997 34
Consolidated Statements of Capitalization as of December 31, 1998 and 1997 35
Consolidated Statements of Changes in Shareholders' Investment for the years ended December 31, 1998, 1997 and 1996 36
Notes to the Consolidated Financial Statements 37-61
Report of Independent Public Accountants 62
(a) 2. Financial Statement Schedules.
The following additional data should be read in conjunction with the Consolidated Financial Statements in Part II, item 8 above. Schedules not included herein have been omitted because they are not applicable or the required information is shown in such financial statements or notes thereto.
Schedule Number Pages in 10-K -------- -------------
I Consolidated Valuation and Qualifying Accounts for the years ended December 31, 1998, 1997 and 1996 71
(a) 3. Exhibits, including those incorporated by reference
Filed -------------------- Exhibit By No. Description Herewith Reference - ------- ----------- -------- --------- 2 Plan of Acquisition, etc. NA NA 3.(i).1 Articles of Incorporation of SEMCO Energy, Inc., as restated July 11, 1989.(a) x 3.(i).2 Certificate of Amendment to Article III of the Articles of Incorporation dated May 16, 1990.(b) x 3.(i).3 Certificate of Amendment to Articles I, III and VI of the Articles of Incorporation dated April 16, 1997.(j) x 3.(ii) Bylaws--last revised December 17, 1998. x 4.1 Trust Indenture dated April 1, 1992, with NBD Bank, N.A. as Trustee.(c) x 4.2 Note Agreement dated as of June 1, 1994, relating to issuance of $80,000,000 of long-term debt.(e) x 4.3 Rights Agreement dated as of April 15, 1997 with Continental Stock Transfer & Trust Company, as Rights Agent.(h) x 4.4 Note Agreement dated as of October 1, 1997, relating to issuance of $60,000,000 of long-term debt.(l) x 9 Voting Trust Agreement. NA NA 10 Material Contracts. 10.1 Short-Term Incentive Plan.(d) x 10.2 Deferred Compensation and Phantom Stock Purchase Agreement (for outside directors only).(f) x 10.3 Supplemental Retirement Plan for Certain Officers.(g) x 10.4 1997 Long-Term Incentive Plan.(h) x 10.5 Stock Option Certificate and Agreement dated October 10, 1996 with William L. Johnson.(i) x 10.6 Stock Option Certificate and Agreement dated February 26, 1997 with William L. Johnson.(i) x 10.7 Employment Agreement dated October 10, 1996, with William L. Johnson.(j) x 10.8 Change of Control Employment Agreement dated October 10, 1996, with William L. Johnson.(j) x 10.9 Form of Change in Control Agreement effective March 20, 1998, for all officers except Mr. Johnson.(n) x
Filed -------------------- Exhibit By No. Description Herewith Reference - ------- ----------- -------- --------- 10.10 Asset Purchase Agreement dated August 9, 1997 between Sub-Surface Construction Co., Stewart Kniff and SEMCO Energy Construction Co., First Amendment to Asset Purchase Agreement, Amendment to Leased Equipment Purchase Agreements and Asset Purchase Agreement, List of Schedules and Exhibits and Agreement to Furnish Schedules and Exhibits.(k) x 10.11 Purchase Agreement between the Company and Merrill Lynch & Co., etc., pertaining to an offering of 1,600,000 Shares of Common Stock.(o) x 10.12 Distribution Agreement between the Company and Merrill Lynch & Co., etc., pertaining to an offering of $150,000,000 Medium-Term Notes and Form of Medium Term Note.(p) x 10.13 Agreement and Plan of Merger dated as of October 30, 1998, between the Company, SEMCO Consultants, Inc. and Jimmy C. Foster and the Press Release announcing the merger.(q) x 10.14 Executive Security Agreement. x 10.15 Split-Dollar Agreement. x 10.16 Deferred Compensation and Stock Purchase Agreement for Outside Directors for 1999. x 11 Statement re computation of per share earnings. NA NA 12 Ratio of Earnings to Fixed Charges. x 13 Annual report to shareholders. NA NA 16 Letter re change in certifying accountant. NA NA 18 Letter re change in accounting principle.(m) x 21 Subsidiaries of the Registrant. x 22 Published report regarding matters submitted to a vote of security holders. NA NA 23 Consent of Independent Public Accountants. x 24 Power of Attorney. x 27 Financial Data Schedule. x 99.1 Proxy Statement dated March 15, 1999.(r) x 99.2 Announcement of agreement to sell SEMCO Energy Services, Inc.(s) x
Key to Exhibits Incorporated by Reference
(a) Filed with SEMCO Energy, Inc.'s Form 10-K for 1989, dated March 29, 1990, File No. 0-8503. (b) Filed with SEMCO Energy, Inc.'s Form 10-K for 1990, dated March 28, 1991, File No. 0-8503. (c) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended March 31, 1992, File No. 0-8503. (d) Filed with SEMCO Energy, Inc.'s Form 10-K for 1992, dated March 30, 1993, File No. 0-8503. (e) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended June 30, 1994, File No. 0-8503.
Key to Exhibits Incorporated by Reference (Continued)
(f) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended September 30, 1994, File No. 0-8503. (g) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended March 31, 1996, File No. 0-8503. (h) Filed March 6, 1997 as part of SEMCO Energy, Inc.'s 1997 Proxy Statement, dated March 7, 1997, File No. 0-8503. (i) Filed with SEMCO Energy, Inc.'s Form 10-K for 1996, dated March 27, 1997, File No. 0-8503. (j) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended March 31, 1997, File No. 0-8503. (k) Filed with SEMCO Energy, Inc.'s Form 8-K dated August 13, 1997, File No. 0-8503. (l) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended September 30, 1997, File No. 0-8503. (m) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended March 31, 1998, File No. 0-8503. (n) Filed with SEMCO Energy, Inc.'s Form 10-Q/A for the quarter ended March 31, 1998, File No. 0-8503. (o) Filed with SEMCO Energy, Inc.'s Form 8-K dated August 13, 1998, File No. 0-8503. (p) Filed with SEMCO Energy, Inc.'s Form 8-K dated October 21, 1998, File No. 0-8503. (q) Filed with SEMCO Energy, Inc.'s Form 8-K dated November 5, 1998, File No. 0-8503. (r) Filed March 11, 1999, pursuant to Rule 14a-6 of the Exchange Act, File No. 0-8503. (s) Filed with SEMCO Energy, Inc.'s Form 8-K dated March 23, 1999, File No. 0-8503.
ITEM 14. (Continued)
(b) On October 23, 1998, the Company filed Form 8-K to file the Distribution Agreement between the Company and the underwriters pertaining to an offering of $150,000,000 Medium-Term Notes.
The Company filed Form 8-K on November 5, 1998, to file the Agreement and Plan of Merger dated as of October 30, 1998, between the Company, SEMCO Consultants, Inc. and Jimmy C. Foster.
(c) The Exhibits, if any, filed herewith are identified on the Exhibit Index.
(d) The financial statement schedules filed are listed under Item 14.(a).2. above.
SIGNATURES
Pursuant to the requirements of Section 13 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.
SEMCO ENERGY, INC.
Date: March 26, 1999 By /s/William L. Johnson ---------------------------------------- William L. Johnson Chairman, President and Chief Executive Officer
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 --------- ----- ----
/s/William L. Johnson Chairman, President and Chief March 26, 1999 - ------------------------ William L. Johnson Executive Officer (Director)
/s/Sebastian Coppola Senior Vice President and March 26, 1999 - ------------------------ Sebastian Coppola Chief Financial Officer (Principal Financial and Accounting Officer)
/s/Daniel A. Burkhardt* Director March 26, 1999 - ------------------------ Daniel A. Burkhardt
/s/Edward J. Curtis* Director March 26, 1999 - ------------------------ Edward J. Curtis
/s/John T. Ferris* Director March 26, 1999 - ------------------------ John T. Ferris
/s/Michael O. Frazer* Director March 26, 1999 - ------------------------ Michael O. Frazer
/s/Harvey I. Klein* Director March 26, 1999 - ------------------------ Harvey I. Klein
/s/Stewart J. Kniff* Director March 26, 1999 - ------------------------ Stewart J. Kniff
/s/Bruce G. Macleod* Director March 26, 1999 - ------------------------ Bruce G. Macleod
/s/Frederick S. Moore* Director March 26, 1999 - ------------------------ Frederick S. Moore
/s/Edith A. Stotler* Director March 26, 1999 - ------------------------ Edith A. Stotler
/s/Donald W. Thomason* Director March 26, 1999 - ------------------------ Donald W. Thomason
*By /s/William L. Johnson March 26, 1999 --------------------- William L. Johnson Attorney-in-fact
SCHEDULE I
SEMCO ENERGY, INC. Exhibit Index Form 10-K
Filed -------------------- Exhibit By No. Description Herewith Reference - ------- ----------- -------- --------- 2 Plan of Acquisition, etc. NA NA 3.(i).1 Articles of Incorporation of SEMCO Energy, Inc., as restated July 11, 1989.(a) x 3.(i).2 Certificate of Amendment to Article III of the Articles of Incorporation dated May 16, 1990.(b) x 3.(i).3 Certificate of Amendment to Articles I, III and VI of the Articles of Incorporation dated April 16, 1997.(j) x 3.(ii) Bylaws--last revised December 17, 1998. x 4.1 Trust Indenture dated April 1, 1992, with NBD Bank, N.A. as Trustee.(c) x 4.2 Note Agreement dated as of June 1, 1994, relating to issuance of $80,000,000 of long-term debt.(e) x 4.3 Rights Agreement dated as of April 15, 1997 with Continental Stock Transfer & Trust Company, as Rights Agent.(h) x 4.4 Note Agreement dated as of October 1, 1997, relating to issuance of $60,000,000 of long-term debt.(l) x 9 Voting Trust Agreement. NA NA 10 Material Contracts. 10.1 Short-Term Incentive Plan.(d) x 10.2 Deferred Compensation and Phantom Stock Purchase Agreement (for outside directors only).(f) x 10.3 Supplemental Retirement Plan for Certain Officers.(g) x 10.4 1997 Long-Term Incentive Plan.(h) x 10.5 Stock Option Certificate and Agreement dated October 10, 1996 with William L. Johnson.(i) x 10.6 Stock Option Certificate and Agreement dated February 26, 1997 with William L. Johnson.(i) x 10.7 Employment Agreement dated October 10, 1996, with William L. Johnson.(j) x 10.8 Change of Control Employment Agreement dated October 10, 1996, with William L. Johnson.(j) x 10.9 Form of Change in Control Agreement effective March 20, 1998, for all officers except Mr. Johnson.(n) x
Filed -------------------- Exhibit By No. Description Herewith Reference - ------- ----------- -------- --------- 10.10 Asset Purchase Agreement dated August 9, 1997 between Sub-Surface Construction Co., Stewart Kniff and SEMCO Energy Construction Co., First Amendment to Asset Purchase Agreement, Amendment to Leased Equipment Purchase Agreements and Asset Purchase Agreement, List of Schedules and Exhibits and Agreement to Furnish Schedules and Exhibits.(k) x 10.11 Purchase Agreement between the Company and Merrill Lynch & Co., etc., pertaining to an offering of 1,600,000 Shares of Common Stock.(o) x 10.12 Distribution Agreement between the Company and Merrill Lynch & Co., etc., pertaining to an offering of $150,000,000 Medium-Term Notes and Form of Medium Term Note.(p) x 10.13 Agreement and Plan of Merger dated as of October 30, 1998, between the Company, SEMCO Consultants, Inc. and Jimmy C. Foster and the Press Release announcing the merger.(q) x 10.14 Executive Security Agreement. x 10.15 Split-Dollar Agreement. x 10.16 Deferred Compensation and Stock Purchase Agreement for Outside Directors for 1999. x 11 Statement re computation of per share earnings. NA NA 12 Ratio of Earnings to Fixed Charges. x 13 Annual report to shareholders. NA NA 16 Letter re change in certifying accountant. NA NA 18 Letter re change in accounting principle.(m) x 21 Subsidiaries of the Registrant. x 22 Published report regarding matters submitted to a vote of security holders. NA NA 23 Consent of Independent Public Accountants. x 24 Power of Attorney. x 27 Financial Data Schedule. x 99.1 Proxy Statement dated March 15, 1999.(r) x 99.2 Announcement of agreement to sell SEMCO Energy Services, Inc.(s) x
Key to Exhibits Incorporated by Reference
(a) Filed with SEMCO Energy, Inc.'s Form 10-K for 1989, dated March 29, 1990, File No. 0-8503. (b) Filed with SEMCO Energy, Inc.'s Form 10-K for 1990, dated March 28, 1991, File No. 0-8503. (c) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended March 31, 1992, File No. 0-8503. (d) Filed with SEMCO Energy, Inc.'s Form 10-K for 1992, dated March 30, 1993, File No. 0-8503. (e) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended June 30, 1994, File No. 0-8503.
Key to Exhibits Incorporated by Reference (Continued)
(f) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended September 30, 1994, File No. 0-8503. (g) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended March 31, 1996, File No. 0-8503. (h) Filed March 6, 1997 as part of SEMCO Energy, Inc.'s 1997 Proxy Statement, dated March 7, 1997, File No. 0-8503. (i) Filed with SEMCO Energy, Inc.'s Form 10-K for 1996, dated March 27, 1997, File No. 0-8503. (j) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended March 31, 1997, File No. 0-8503. (k) Filed with SEMCO Energy, Inc.'s Form 8-K dated August 13, 1997, File No. 0-8503. (l) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended September 30, 1997, File No. 0-8503. (m) Filed with SEMCO Energy, Inc.'s Form 10-Q for the quarter ended March 31, 1998, File No. 0-8503. (n) Filed with SEMCO Energy, Inc.'s Form 10-Q/A for the quarter ended March 31, 1998, File No. 0-8503. (o) Filed with SEMCO Energy, Inc.'s Form 8-K dated August 13, 1998, File No. 0-8503. (p) Filed with SEMCO Energy, Inc.'s Form 8-K dated October 21, 1998, File No. 0-8503. (q) Filed with SEMCO Energy, Inc.'s Form 8-K dated November 5, 1998, File No. 0-8503. (r) Filed March 11, 1999, pursuant to Rule 14a-6 of the Exchange Act, File No. 0-8503. (s) Filed with SEMCO Energy, Inc.'s Form 8-K dated March 23, 1999, File No. 0-8503.